What If California Were Greece?

The Separation of Bank and State

Coming Together or Flying Apart?

Europe in Recession Meanwhile, Back at the Ranch

A Slowing US Economy

Where’s My Quantitative Easing?

Home for a Week! New York and Italy

It is simply hard to tear your eyes away from the slow-motion train wreck that is Europe. Historians will be writing about this moment in time for centuries, and with an ever-present media we see it unfold before our eyes. And yes, we need to tear our gaze away from Europe and look around at what is happening in the rest of the world. There is about to be an eerily near-simultaneous ending to the quantitative easing by the four major central banks while global growth is slowing down. And so, while the future of Europe is up for grabs, the true danger to global markets and growth may be elsewhere. But, let’s do start with the seemingly obligatory tour of Europe.

What If California Were Greece?

David Zervos is the managing director and chief market strategist of Jefferies and Company. He is an astute observer of Europe and brings a very interesting perspective to the trade, with his Greek heritage. I got an email this morning from him that I wish I had written. It is hard for many of us in the US to understand just how deeply flawed the structure of the European Monetary Union is (as opposed to the actual political union which, for all its flaws, seems to work quite well). David came up with a very fun analogy that makes the problem readily apparent. What if California behaved like Greece and the rest of the US was asked to pay for its debts and other obligations? What would ensue? So, rather than paraphrase what is already a very solid if short essay, let’s turn to David:

The Separation of Bank and State

By David Zervos

“The euro monetary system is flawed. It is a system that was cobbled together for political purposes; and sadly it was set up in such a way that each member state retained significant sovereign powers – most importantly the ability to exit the system and default on debts in times of stress. There is virtually NO federal power in the Union, as witnessed by the complete breakdown of the Maastrict and Lisbon treaties. In fact, what we are seeing today is that the structure of the monetary system is so poorly designed, it actually creates perverse fiscal linkages across member states that incentivize strategic default and exit. Our new leader of the Greek revolt, Mr CHEpras, has figured this one out. And in turn he is holding Angie hostage as we head into June 17th!

[JFM note: CHEpras is David’s tongue-in-cheek name for the 37-year-old leader of the Syriza Party, Alexis Tsipras, whose rhetoric does indeed resemble Che Guevara’s from time to time.]

“To better understand these flaws in the Eurosystem, let’s assume the European monetary system was in place in the US. And then imagine that a US ‘member state’ were to head towards a bankruptcy or a restructuring of its debts – for example, California.

“So let’s suppose California promised its citizens huge pensions, free health care, all-you can-eat baklava at beachside state parks, subsidized  education, retirement at age 45, all-you-can-drink ouzo in town squares, and paid 2-week vacations during retirement. And let’s assume the authorities never come after anyone who doesn’t pay property, sales, or income taxes.

“Now it’s probably safe to further assume that the suckers who bought California state and municipal debt in the past (because it had a zero risk weight) would quickly figure out that the state’s finances were unsustainable. In turn, these investors would dump the debt and crash the system.

“So what would happen next in our US member-state financial crisis? Well, the governor of California would head to the US Congress to ask for money – a bailout. Although there is a‘no-bailout’ clause in the US Constitution, it would be overrun by political forces, as California would be deemed systemically important. The bailout would be granted and future reforms would be exchanged for current cash. The other states would not want to pay unless California reformed its profligate policies. But the prospect of no free baklava and ouzo would then send Californians into the streets, and rioting and looting would ensue.

“Next, the reforms agreed by the Governor fail to pass the state legislature. And as the bailout money slows to a trickle, the fed-up Californians elect a militant left-wing radical, Alexis (aka Alec) Baldwin, to lead them out of the mess!

“When Alexis takes office, US officials in DC get very worried. They cut off all California banks from funding at the Fed. But luckily, the “Central Bank of California” has an Emergency Liquidity Assistance Program. This gives the member-state central bank access to uncollaterized lending from the Fed – and the dollars and the ouzo keep flowing. But the Central Bank of California starts to run a huge deficit with the other US regional central banks in the Fed’s Target2 system. As the crisis deepens, retail depositors begin to question the credit quality of California banks; and everyone starts to worry that the Fed might turn off the ELA for the Central Bank of California.

“Californians worry that their banks will not be able to access dollars, so they start to pull their funds and send them to internet banks based in ‘safe’ shale-gas towns up in North Dakota. Because, in this imaginary world, there is no FDIC insurance and resolution authority (just as in Europe), the California banks can only go to the Central Bank of California for dollars, and it obligingly continues to lend dollars to an insolvent banking system to pay out depositors. In order to reassure depositors, California announces a deposit-guarantee program; but with the state’s credit rating at CCC, the guarantee does nothing to stem the deposit outflow.

“In this nightmare monetary scenario, with the other regional central banks, ELA, and Target2 unable to stop the bleeding – and no FDIC – the prospect of a California default FORCES a nationwide bank default. The banks automatically fall when the state plunges into financial turmoil, because of the built-in financial structure. A bank run is the only way to get to equilibrium in this system.

“There is sadly no separation of member-state financials and bank financials in our imaginary European-like financial system. So what’s the end game? Well, after Californians take all their US dollars out of California banks, Alexis realizes that if the Central Bank of California defaults, along with the state itself and the rest of its banks, the long-suffering citizens can still preserve their dollar wealth and the state can start all over again by issuing new dollars with Mr. Baldwin’s picture on them (or maybe Che’s picture). This California competitive devaluation/default would leave a multi-trillion-dollar hole in the Fed’s balance sheet, and the remaining, more-responsible US states would have to pick up the tab. So Alexis goes back to Washington and threatens to exit unless the dollars and ouzo and baklava keep coming.

“And that’s where we stand with the current fracas in Europe!

“Can anyone in the US imagine ever designing a system so fundamentally flawed? It’s insane! Without some form of FDIC insurance and national banking resolution authority, the European Monetary System will surely tear itself to shreds. In fact, as Target2 imbalances rise, it is clear that Germany is already being placed on the hook for Greek and other peripheral deposits. The system has de facto insurance, and no one in the south is even paying a fee for it. Crazy!

“In the last couple days I have spent a bit of time trying to find any legal construct which would allow the ELA to be turned off for a member country. I can’t. That doesn’t mean it won’t be done (as the Irish were threatened with this 18 months ago), but we are entering the twilight zone of the ECB legal department. Who knows what happens next?

“The reality is that European Monetary System was broken from the start. It just took a crisis to expose the flaws.  Because the member nations failed to federalize early on, they created a structure that allows strategic default and exit to tear apart the entire financial system. If the Greek people get their euros out of the system, then there is very little pain of exit. With the banks and government insolvent, repudiating the debt and reintroducing the drachma is a winning strategy! The fact that this is even possible is amazing. The Greeks have nothing to lose if they can keep their deposits in euros and exit!

“Let’s thank our lucky stars that US leaders were smart enough to federalize the banking system, thereby not allowing any individual state to threaten the integrity of our entire financial system. There is good reason for the separation of the banking system and the member states. And Europe will NEVER be a successful union until it converts to a state-independent, federalized bank structure. The good news is that our radical Greek friend Mr CHEpras will probably force a federalised structure very quickly. The bad news (for him) is that he will likely not be part of it! I suspect this Greek bank run will be just the ticket to precipiate a federalized, socialized, stabilized Europe. Then maybe we can get back to the recovery and growth path everyone in the US is so desperately seeking.

“Good luck trading.”

Coming Together or Flying Apart?

The debate among very knowledgeable individuals and institutions as to the future of Europe is intense. There are those who argue that the cost of breaking up the eurozone, even allowing Greece to leave, is so high that it will not be permitted to happen. Estimates abound of a cost of €1 trillion to European banks, governments, and businesses, just for the exit of Greece. And that does not include the cost of contagion as the markets wonder who is next. Keeping Spanish and Italian interest-rate costs at levels that can be sustained will cost even more trillions, as not just government debt but the entire banking system is at stake. Not to mention the pension and insurance funds. If the cost of Greece leaving is €1 trillion, then who can guess the cost of Spain or Italy?

A total Greek default wipes out more than twice the ECB balance sheet. That means the remaining countries will have to put twice as much into the ECB as their present commitment, just to get the ECB back to where it technically stands today (because theassumption is still that Greek debt is good, and so the ECB is still lending money to the Greek Central Bank).

Then there are those who argue there is no wayGreece can stay in the eurozone. The political costs are just too high, not only to the Greek people but to the rest of Europe. How long can Greece demand that Europe cover its government deficits, when its own citizens are not diligent in paying taxes? Listen to Alexis Tsipras, the leader of Syriza, at a campaign rally:

“There’s one real choice in these elections: the bailout or your dignity…

“We want all the peoples of Europe to hear us, and we want their leaders to hear us when we say that no [country] chooses to become servile, to lose their dignity or commit suicide… We are the political party that with the help of the people will fulfill our campaign promises and cancel this bankrupt bailout deal.”

The Syriza Party appears to be ahead in the polls as I write, but that has shifted several times this week. Not only do European leaders not know what will happen, apparently even the Greeks cannot make up their minds, if we are to believe the polls. They want to stay in the eurozone but don’t want to have to endure the cuts in spending that simply moving toward a balanced budget will requirs. This is a classic case of wanting to have your cake and eat it too.

I simply don’t know what the eurozone will do in the next year, or even the next month. If Syriza wins the elections and forms the government, how can Europe back down and give them what Tsipras is demanding? And if the Greeks continue to pull their money from Greek banks (and it is now billions a week), then it will not be very long before they have their euros everywhere but in Greece, and they will in fact have little reason to stay in the eurozone, as Zervos points out.

This latter fact will not be lost on Spanish and Italian voters. If there is not that great a cost to Greece for leaving; and especially if Greece, after a period of severe recession/depression, starts to rebound; then voters all over Europe will be paying close attention. Some will ask why they should not default as well, and others will wonder why they are paying taxes to support other countries that might leave.

Even if European leaders have no real idea what will actually happen, there are some things that are more likely than others. I think the whole idea of eurobonds is dead on arrival. Who would be responsible for paying that bond structure, which would soon be in the trillions of euros? Some European authority? The EU itself, which would then need to levy taxes and set national budgets? I can’t really see any country giving up control of its budget to Brussels, let alone give the EU the power to raise taxes. And if the eurozone has a problem raising a relatively paltry €400 billion for the ESM, etc., from the various governments, how can it expect to get the authority to raise trillions? Does anyone really think the German Bundestag will agree to their share of that?

That then leaves the options of either designating the ESM or some other entity as a bank that can borrow relatively unlimited amounts from the ECB, or having the ECB monetize the debts of various governments in trouble and saddling them with a program of budgetary reforms (which are clearly not popular if you are the one being reformed!).

I still think it is likely that Greece will leave the eurozone. It makes sense if you are Greece; and even though it will cost the other eurozone members huge sums of money, I think they are getting “Greek fatigue.” But let’s stay tuned, as they say.

Europe in Recession

Germany was able to sell €4.56 billion ($5.8 billion) of two-year bonds at a 0% coupon interest rate on Wednesday. That was not a typo. Why would people give Germany money to use for two years at no cost?

I can think of several reasons, but the one I think is most likely – and the one that will not be admitted in polite circles – is that it is basically a very low-cost call option on the possibility of Germany leaving the eurozone. If Germany left, they would likely denominate their bonds in Deutsche marks, which would rise in value over those of the countries that remained in the euro.

But this also points up the fact that Germany is falling into recession, hard on the heels of the rest of Europe, which is mostly already there – some countries severely so. Leading economic indicators as well as purchasing-manager indexes are down all across Europe. But the saddest statistic is that of youth unemployment. Below is a chart from Reuters (courtesy of Frank Holmes at US Global). Only Germany is seeing its youth unemployment rate fall below 10%.

Meanwhile, Back at the Ranch

This letter is translated into Chinese, Spanish, and Italian; so I have to write with an international audience in mind, and also remember that I am of a certain age. Some concepts may not translate well, either to other languages or across generations. So let me set up the theme for younger readers and those not familiar with early 20^th-century American culture. In the dawn of film, cowboy movies were all the rage.  These were typically low-budget, and most were shot on the same set and ranch in southern California. The same saloons, jails, large rocks, and dirt roads kept showing up in movie after movie; but no one much noticed, back then. The magic of movies was still fresh.

You would watch your hero (you knew he was the good guy, because he wore a white hat) chase bank robbers and cattle rustlers and duke it out with gunslingers; and there was usually at least one pretty girl involved. In the era of silent movies, there would literally be a title graphic that said, “Meanwhile, Back at the Ranch” when there was a segue between the action involving the hero and the bad guys and the doings of the people back home on the ranch.

So then, “meanwhile, back at the global economy,” let’s look at a few graphs and some data to see what is happening in the rest of the world.

First of all, China is really beginning to slow down from its torrid pace of growth. Thr growth of their manufacturing output has fallen for seven straight months, and it is now contracting. Media reports everywhere are talking about actual statistics or anecdotal stories from Chinese merchants and businesses. Construction is under real pressure, as are real estate prices. Just as in the US or Europe, when construction starts to slow it affects all sorts of smaller businesses that supply products to people building or remodeling their homes.

A few data points. Deposit growth in China is slowing rapidly, and money supply suggests a decelerating economy. The ratio of M1 to M2 growth suggests an even weaker economy than the contracting purchasing manager’s index.  The M1-M2 ratio is now back to where it was in the last financial crisis.

Let’s look at two charts from Credit Suisse. I have long been concerned about the very high percentage of GDP growth in China that is attributable to direct investment, bank loans, and infrastructure spending. While all of those are good things, the levels in China  are without precedent anywhere in the world that I am familiar with, and have been there a long time.

What happens when you have to slow down investment and try to become a more consumer-driven economy? The transition is generally not smooth.  And what happens when you try and do that when your largest customer (Europe) is in recession? And when the bank lending from Europe that finances the spending of many of the developing nations you sell to begins to dramatically shrink?

Reports from around the world show South African and Australian mines with lower sales, growth in Taiwan slowing and Great Britain in recession. The MSCI World Index, which tracks equity markets around the globe, is down more than 9% since mid-March.

A Slowing US Economy

The US economy is also starting to slow. Job growth is getting weaker. Food stamps are at an all-time high. The effects from stimulus spending have just about gone away, and there are large numbers of people falling off extended unemployment benefits.  Lakshman Achuthan, of the Economic Cycle Research Institute (ECRI), has recently reaffirmed his belief that a return to economic contraction is likely in 2012, noting that the coincident data used to officially define economic-cycle boundaries continue to signal slowing growth. Achuthan is a very sober fellow, and you have to pay attention when he makes these calls. ECRI does not make them lightly.

Let’s also look at a couple charts from my friend Rich Yamarone, the chief economist at Bloomberg. (We will be together at a symposium at the University of Texas in Austin, on June 7, along with David Rosenberg.) Rich has also been stating that he believes the US economy is headed for recession, for a different set of reasons.

At our dinner meeting last week (as indeed he has been for months) he was talking about the fall in real disposable personal income. It is hard to get growth when incomes are not rising .

And he too is worried about the fact that government stimulus (transfer payments, unemployment benefits, welfare, food stamps, etc.) has had a major effect on consumer spending, but as people fall off extended unemployment benefits (and they are, by the hundreds of thousands each month) personal income could actually drop.

Where’s My Quantitative Easing?

The recent round of global quantitative easing is beginning to ebb. Europe, Great Britain, and the US are all wrapping up their stimulus and have not announced plans for any more. China is more or less on hold until the leadership changes in October (or that is what most observers I read seem to think).

The recent QE had provided a clear boost to commodity prices and stocks, and the anticipation of withdrawal seems to be having a depressive effect on market prices. This was the third round of global QE, and each round has resulted in less real benefit than the previous one. There is reason to believe that another round would continue that trend. While it is probable that the ECB will soon take action, as Europe is clearly in recession, there seems to be no such consensus as yet in the US. And with an election coming in November, if the Fed is going to do anything, they have just two meetings left (on June19-20 and August 1) before September, at which point the economy would have to be in very serious trouble for them to do anything before the election – which then takes us out to the December meeting.

Since the recent most QE will still be in effect at the time of the June meeting, that would leave August 1 for an announcement. We will only have two unemployment reports between now and that meeting. They will therefore be of more than usual importance. We will be watching.

Home for a Week! New York and Italy

I will be in New York the first weekend in June, then jog over to Philadelphia to speak on Monday and Tuesday at an advisor conference with partner Steve Blumenthal of CMG (619-989-9090). And then back home. As I mentioned above, I will be in Austin June 7. Then the next week it’s back to NYC for two days and then to Chicago the following week, both for events with my partners at Altegris (details later).

And then I am off to Tuscany for two weeks! I will be reading and writing, of course, but doing it under the Tuscan sun and on a more relaxed schedule. Tiffani will be there, and a number of friends are stopping by. I am really looking forward to it.

I was in Atlanta this week. I have to confess that while I love Atlanta I hate flying there, as it is a long taxi ride to wherever I seem to stay, and I always manage to get there during rush hour. This week I arrived at 5 pm, just in time to sit in traffic. As I was walking to the other side of the airport to hail a taxi, I passed a sign that read “Train.” A few questions later and I found the train, which, it appeared, would take me close to my hotel. Why not? I paid the princely sum of $2.50 and hopped on the train, which was uncrowded and quite nice. I got off in downtown, walked out, and asked directions to my hotel.

The very helpful attendant told me to go back and get on the train to the next station. “Just ask that guard over there, and he will let you back in.” And he did. And so I got off at the next station and walked out (again directed to go through the emergency exit, as my ticket had been used up), and another attendant (this time a very nice lady) told me I needed to walk to the other side of the station. No problem. I started walking.

“Wait. Not that way!” she called.“Let me get you back into the station. When you get to the other side just go through the emergency exit. And slow down, young man” (even though I was clearly her senior by a few years).  It was nice to be treated in such a friendly way. Not my normal experience on trains and subways. I do so like Southern hospitality.

Which brings to mind an experience in Paris, about two years ago. I find the Paris subway quite handy at times. I was staying at a hotel right next to a station. Walking back from a meeting at the Central Bank of France, I got thoroughly lost, totally turned around and not in any district I had ever seen. Frustrated, I decided to find a subway and just take it back to the hotel. THAT I could do. So I asked a person on the street where the subway was, got directions, and started out on a rather longish hike. No subway. I asked again. More directions. And no subway station. I asked a third and then a fourth time. I was getting very upset. My experience in past years had been that even Parisians do not intentionally mislead tourists, even Texans. I simply could not understand what was going on.

Not knowing what to do, I paused and looked around. And then I saw the subway. Except that it was a Subway sandwich shop. If you want the train in Paris, you ask for the Metro.

Oh well. So much for the seasoned traveler. (I wonder how that story gets translated.)

It is time to hit the send button. I know it dates me, but this letter got me thinking about Hopalong Cassidy, Roy Rogers, The Lone Ranger, and the TV and B movies of my youth. It’s all there on the internet now. Back then, we lived for the weekend, to hear the words, “A fiery horse with the speed of light, a cloud of dust, and a hearty ‘Hi Yo Silver!’”  It meant the Lone Ranger was riding into our living room.

It is quite a remove from where I am today to the country boy growing up in rural Texas. But you still remember the lessons. Sit tall, talk straight, and keep your word. Be kind to animals, polite to ladies, and do the right thing, no matter what. Good lessons then and now, only I don’t know whether the same concepts are being imparted by the video games my kids play. Different times, for sure; and I’m not sure the “good old days” were better; we just remember them that way.

Have a great week. Tomorrow is my youngest son’s 18^th birthday. They are all grown up now.

Your hard-flying, straight-shooting analyst,

John Mauldin

John@FrontlineThoughts.com

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German Manufacturing Output Falls To A 35-Month Low. I think that the crisis will eventually drag even mighty Germany into recession. Their customers are sinking.

Cullen Roche tongue in cheek suggests kicking Germany out of the Eurozone. In the comments section I agree on his overall analysis, but do not believe that any of the countries in Europe truly want real fiscal and political integration, which would end their individual national sovereignty. In my mind the issue isn’t Germany, but collective denial. As always with Cullen, the discussion is frank, civil and educational.

Meanwhile the Greeks are busy deluding themselves about their situation:

“Even if we go bankrupt we need to tell them clearly that we won’t leave the euro in any event. They’ll have a bankrupt country in the euro, which means other countries can go bankrupt as well and the whole euro zone will blow up,” said electrician Thanasis Zahariadis, 47.

“So they won’t let us go bankrupt, no way. These are just threats. I’m going to vote anti-bailout.”

[...]

“There’s a lot of money in this country, they just need to tax the rich and it would solve so many problems,” said seamstress Argiro Maniati, 55. “The big parties brought us here, to poverty and suicide, and they are terrorizing us to make us accept tough measures.”

[...]

“Empty threats!” said Nikos Sokos, 29, who works in a cafe in central Athens. “There’s no way they’re going to kick us out. There won’t be a euro zone if they do that.”

[...]

“No one can force us to leave the euro. Now that they have us, they’re stuck with us,” he said. “If they change the laws to force us out, then there will be no euro zone. They’re just barking to scare us but actually they’re the ones who are scared,” he added.

Yeah, this will end well.

One of the trends I am most fond of in contemporary society is the resurrection of 19th century spirits and their associated cocktails. It fits nicely with my fondness for cocktails, the obscure and history. Combine all three and I am truly smitten. The indispensable liver and pen of Jason Wilson has been exploring this trend for years at the Washington Post and this week introduced me to several new liqueurs, including a 19th century Curacao:

“I really thought this was going to be a niche-of-a-niche product for a few geeks and misfits like us,” Gabriel says of his dry Curacao.

Well, I know that describes me. Read and enjoy. If you wish, you can have a brandy cocktail while doing so:

Ingredients:

• Ice
• 2 ounces cognac
• 1/2 ounce orange liqueur, preferably Pierre Ferrand Dry Curacao (see headnote)
• 1 dash Peychaud’s bitters (may substitute Angostura bitters)
• Twist of lemon peel, for garnish

Directions:

Fill a mixing glass halfway with ice. Add the cognac, orange liqueur and bitters. Stir vigorously, then strain into a chilled cocktail (martini) glass. Garnish with the lemon peel twist.

A nice Brandy Cocktail might just be what the doctor ordered for EU policy makers. Ireland may need another bailout.

As Europe gets cheaper it is tempting to just buy an ETF and start averaging into Europe and buy in force if there is a crisis. However, European indexes have always included lots of Eurozone bank and financial institutions. Given the non trivial possibility that bank shareholders could be completely wiped out if the Euro breaks up, or even under less disastrous circumstances, that seemed unappealing. However, the market seems to be taking care of that:

“…eurozone bank valuations now make up only 8% of the eurozone’s total market capitalization, the lowest level in nearly 40 years and down from more than 20% at its height in 2007.”

Jeffries now seems to be moving toward my long held views about where China is likely headed:

“While the contagion once again spreads through Europe, there is enormous denial over the Chinese economy.”

The government of China is concerned as well:

Continued weakness in China’s economic data, as well as growing risks of a Greek exit from the euro zone, will drive Beijing to launch aggressive stimulus measures in order to prevent a further deterioration.

Personally, if the bubble has burst stimulus has a very delayed effect. Not to mention that the type of stimulus contemplated is a questionable effort anyway given the type of bubble it is:

Stimulus has been a benefit to China’s economy for 2009-2011 in the form of higher GDP growth. The potential second order consequence of FAI (Editor: Fixed Asset Investment) growing at 25-30%pa (2-3x GDP) is the significant spike in projects under construction in 2009-2011 becomes a spike in completed projects in 2012-13. If construction activity has significantly outpaced demand (we think it has using sales as a proxy) then the excess is likely to become inventory. The prospect of renewed stimulus is the obvious caveat; but it’s not clear to us that more stimulus will help given our view that a key cause of the underlying weakness is a problem of excess inventories caused by too much construction.

The biggest and most concerning data point is this:

China’s biggest banks may fall short of loan targets for the first time in at least seven years as an economic slowdown crimps demand for credit, three bank officials with knowledge of the matter said.

Let us understand what is going on here. China is trying to loan more money but not enough people want to take out loans. That sounds an awful lot like a collapse in demand from credit that typically accompanies a popping bubble and its associated debt deflation.

For all my concerns about China, it is India that may be facing a mass default and restructuring as devaluation looms.

In fact, all the BRIC’s seem to be running into a wall.

Markets may be struggling, but WalMart has been on a tear. Wish we had bought even more.

Okay, JP Morgan has suspended their buyback program. I am generally not a fan of buybacks, but this decision leaves me scratching my head.

Speaking of JP Morgan, would Glass Steagall have prevented the financial crisis? Obviously there were regulatory issues, but frankly the calls for regulation (for example, by Elizabeth Warren) seem poorly thought out:

The first domino to nearly topple over in the financial crisis was Bear Stearns, an investment bank that had nothing to do with commercial banking. Glass-Steagall would have been irrelevant. Then came Lehman Brothers; it too was an investment bank with no commercial banking business and therefore wouldn’t have been covered by Glass-Steagall either. After them, Merrill Lynch was next — and yep, it too was an investment bank that had nothing to do with Glass-Steagall

The first domino to nearly topple over in the financial crisis was Bear Stearns, an investment bank that had nothing to do with commercial banking. Glass-Steagall would have been irrelevant. Then came Lehman Brothers; it too was an investment bank with no commercial banking business and therefore wouldn’t have been covered by Glass-Steagall either. After them, Merrill Lynch was next — and yep, it too was an investment bank that had nothing to do with Glass-Steagall.

Next in line was the American International Group, an insurance company that was also unrelated to Glass-Steagall. While we’re at it, we should probably throw in Fannie Mae and Freddie Mac, which similarly, had nothing to do with Glass-Steagall.

Now let’s look at the major commercial banks that ran into trouble.

Let’s first take Bank of America. Its biggest problems stemmed not from investment banking or trading — though there were some losses — but from its acquisition of Countrywide Financial, the subprime lender, which made a lot of bad loans — completely permissible under Glass-Steagall.

What about Wachovia? Its near-collapse was largely a function of its acquisition of Golden West, a mortgage lender that saddled it with billions of dollars in bad loans.

Citigroup’s problems are probably the closest call when it comes to whether Glass-Steagall would have avoided its problems. It gorged both on underwriting bad loans and buying up collateralized debt obligations

In that case, Glass-Steagall would have done two things: it would have prevented the trading losses and it also would have kept Citigroup from getting so big, which was one of the reasons it required a bailout.

Gold mining stocks, as measured by the AMEX Gold Bugs Index (HUI), are down nearly 40% from their August 2011 high. Representative ETFs such as GDX and GDXJ as down similar amounts, if not more.  Mining company stock prices look to be falling into the abyss.

While buying mining stocks here could certainly look foolish in the near-term, NOT accumulating positions, or selling them for that matter, is likely to be the bigger mistake over the long term.

Gold mining stocks are attractive here for three primary reasons:

1. The sentiment on gold, and gold mining stock in particular, is at extreme bearish levels.

2. They are historically very cheap by a variety of relative and absolute measures of valuation.

3. The macro environment is likely to turn very supportive, thereby improving the fundamentals of the stocks, reversing the negative sentiment, and driving the valuations higher.

All That Glitters?

The price of gold, being a non-productive asset and all, has always been subject to the changing whimsy of investors/collectors/hedgers/speculators. Yet the extreme change from bullish to bearish sentiment over the last 6-9 months has been pretty incredible.

This is true when you consider the opinion of the public:

source: www.sentimentrader.com

Or the opinion of market professionals:

as of 04/17/12 source: http://www.kitco.com/ind/Holmes/20120417.html

And also true for the publishers of Gold-focused investment newsletters, who now recommend a net short -14.8% position in the anti-currency monetary unit:

source: www.sentimentrader.com

A corollary to poor sentiment on gold is the overwhelmingly bullish sentiment with respect to the US Dollar

source: www.sentimentrader.com

Of course, one does not have to be bearish on the dollar versus other paper currencies like Euro, Yen, Pound, Aussie or Canadian Dollar, etc. to be bullish on gold. Gold can just as easily strengthen (or weaken for that matter) against those other currencies more than it does against the dollar to have a scenario where both gold and the US trade weighted dollar move in the same direction.

The extreme pessimism is also visible in mining stocks, which do not necessarily trade congruently with the price of the metal on which their business relies (more on this below). Please consider the sector sentiment measurement, again from wwww.sentimentrader.com. As of March 28, 2012 the extreme pessimism for gold stocks stood out relative to the rest of the market:

source: www.sentimentrader.com

Since then, negative sentiment in other sectors has started to catch up with the mining stocks:

source: www.sentimentrader.com

What investors say is another matter from what they do. An investors have been pulling away from gold-related investments. This is true when one looks at the ETFs and ETNs that track gold, which the World Gold Council estimates saw a 58% DECLINE in the volume of gold purchased in 2011 despite rising prices and growing global demand for physical gold.  And it is also true for fund flows into mining stock related funds as evidenced by the Rydex data

source: DecisionPoint.com

Valuation Matters

Are gold mining stocks cheap? The answer is yes, by almost any objective measure. One way to look at mining stocks is to compare them to the price of gold itself.

source: Sitka Pacific; Stockcharts.com

While the instructive, this measure doesn’t do you a lot of good if the price of gold is set to drop precipitously. Consider the case of 1980, when gold was experiencing an epic top and the mining stocks seemed to anticipate the lack of sustainability of the move, driving ratio of miners to gold to low levels. That said, the ratio has provided a pretty good clue to what future long-term returns will look like. Consider the following chart from John Hussman:

source: John Hussman, http://www.hussmanfunds.com/wmc/wmc111121.htm

However, the miners are also cheap on a variety of traditional metrics such as price to earnings and price to cash flow ratios. Consider the trailing, current, and estimated ratios depicted for these three large mining companies. While one must be careful of future estimates of operating metrics and the consensus estimates are likely to be wrong in some way (please see my prior post, Run, Don’t Walk Away From Forward P/Es) when I see single digit P/E ratios and mid single digit price to cash flow ratios, I pay attention.

Select Senior Mining Stocks Are Cheap

Of course, the true value of the mining stocks resides not simply in their ability to generate cash flow over the next few years, but in the intrinsic value of the resources that the companies can reasonably expect to extract. Even with long-term gold price estimates well below current prices, the stocks are trading cheap relative to their estimated Net Asset Value. The following chart shows the senior mining stocks price to estimated Net Asset Value courtesy of BofA Merrill Lynch.

Senior Mining Stocks: Price to NAV source: BofA ML

By many measures, Junior mining and exploration stocks are even cheaper. I know of several that trade for little more than the net cash on the balance sheet, despite strong evidence of proven and probable gold reserves. These companies will likely be acquired at some point. However, there are too many caveats to enumerate here, so I’ll leave further inquiry to the eager and opportunistic among you.

Determining whether or not an investment is attractive requires understanding WHY something is mispriced, as understanding market expectations is equally important as fundamentals.

Market expectations for gold stocks seem to relying on two key assumptions:

1. The price of gold will not go up significantly and may have a long-term average well below today’s price.

2. The costs for mining will continue to grow at a fast rate, negatively impacting margins and earnings growth.

These two conditions have certainly been in place over the last 6 months, a period which has seen mining stocks decline by approximately 25%. Mr. Market is once again extrapolating recent trends into the indefinite future which can be particularly dangerous at turning points. Anticipating a change in one or both of these two conditions may set the stage for a meaningful rally in mining stock shares.

Concerning the price of gold…

A review of research on gold and silver mining stocks reveals that analysts use long-term price forecasts for gold of around $1,200 when attempting to value the companies. Additionally, the sentiment data demonstrated above indicates that market participants hold little hope that the price of gold is set to rise from it’s current level of below $1,600/oz.

There have been numerous pressures on the price of gold, ranging from USD strength making gold more expensive to foreign buyers to strikes by gold merchants in India to a general liquidation mentality to the markets in the last few weeks.

However, what appears to be completely absent from the market’s current assessment of gold and silver mining stocks is the likely actions by the Fed and other central banks in the coming months and years in response to lower trend growth in global GDP and the ongoing sovereign debt crisis. In a point made by colleague Brian McAuley in a series of recent client letters, the Fed and other central banks will likely print a lot of money in the coming years in response to slower economic growth and high government debt levels. On a global scale, this money printing has continued almost without interruption since 2007, and over the past two years it has accelerated.  The balance sheets of the eight largest central banks tripled from 2007 through 2011, and during that time the price of gold and silver also tripled. Sitka Pacific colleague Mish, has provided a nice update here courtesy of Saxo Bank:

source: Saxo Bank via Mish’s Global Economic Analysis

However, even with this dramatic central bank balance sheet expansion, economic growth remains slow and we have yet to deal with the eventual impact of our buildup in government debt.  That impact is just starting to be felt in Europe, and it has resulted in a stalled Eurozone economy and a dramatic expansion of the European Central Bank’s balance sheet to the tune of $1.3 Trillion which the ECB handed out to banks in late 2011 and early 2012 via LTROs.  The U.S. will likely face a similar set of circumstances at some point in the coming years, and when we consider the likely path of central bank balance sheets within the broader context of low growth and high debt, it seems very likely the expansion we’ve seen in recent years will only continue, supporting gold prices further. It is notable that even a breath of the potential for future easing which came from the FOMC’s April meeting notes were enough to stop gold’s slide and take metal prices higher the last few days.

Sitka Pacific CIO Brian McAuley writes that

with the current sell-off in miners, the market is factoring in no additional central bank activity in the coming years and a decline in gold and silver prices beyond the declines seen since last summer, to the point where many mining companies will become only marginally profitable.  While it is always possible gold and silver prices could decline in the short-term, especially if market conditions were to worsen dramatically before additional easing by the Fed, the current panic out of gold and silver mining stocks appears to be a substantial long-term opportunity in light of our economic circumstances.

Concerning the price of everything else…

Consider the year over year change in cash cost estimates for the 1st quarter of 2012 from the analysts at BofA. With costs “unexpectedly” rising so fast, it is no wonder so many holders rushed for the door!

source: BofA Merrill Lynch

So while miners are reporting record earnings and cash flows (when it costs you around $600 to produce something that you can sell for $1,600, life is pretty good) investors are disappointed the earnings are not currently growing anywhere near revenues. The list of things driving mining costs higher is daunting:

• Energy prices, especially diesel
• Mining equipment prices, driven by higher base metal prices among other things
• Wages for relatively scarce mining-related labor (though SG&A appears fairly well contained)
• Merger & Acquisition costs
• Taxes, Environmental and Regulatory Costs, etc.

Source: stockcharts.com — lines represent average prices for each year

Please see  Mish’s post 12 Predictions by Michael Pettis on China; Non-Food Commodity Prices Will Collapse Over Next Three to Four Years; Nails in the Hard Landing Coffin?

If mining stock prices are being held back by a negative view of the gold price and concern over input costs then the shares should rally if either one of these conditions is resolved favorably. The input costs for miners will decline if the economy weakens from here. The reversal in the price oil the last few weeks seems to be confirming this view. At the same time, it seems likely that evidence of further economic weakness, regardless of the origin, is going to be met with a policy response that will benefit gold.

There is strong historical evidence that mining stocks respond very favorably to environments where the economy is weakening, real interest rates are falling, and the stocks are priced inexpensively relative to the metal. As John Hussman illuminated way back in 1999

Not surprisingly, the combination of all of these is rare but extremely powerful. In the rare instances when 1) The rate of inflation has been higher than 6 months earlier, 2) Treasury bond yields have been lower than 6 months earlier, 3) the NAPM Purchasing Managers Index has been below 50, and 4) the Gold/XAU ratio has been above 4.0, the XAU has soared at an astounding rate of 123.63% annualized. In contrast, when none of these have been true, the XAU has plunged at -53.21% annualized. That’s a gaping difference

Since 1999, the combination of those factors has become increasingly less rare. So has overly accomodative monetary policy and money printing. Ditto for spectacular gains in mining company shares.

The timing of these events is highly uncertain, but not really that important. The incredibly cheap valuations for mining stocks coupled with the extreme bearish sentiment provides for a substantial margin of safety. Mining company stock prices look to be falling into the abyss; I am jumping in after them.

The brokers there hated him (and Steven Roach) for being so obstinately gloomy. It isn’t great for business generally. I had a different mindset. I went to Morgan Stanley because someone at the top was bearish and it was obvious at the time (at least to me) that it was the right thing to be.

They are sticking to it:

On Oct. 6, 2011, the MSSB Global Investment Committee recommended (and still does) that investors overweight select safe-haven assets and underweight select risk assets, reflecting global concerns about policy efficacy, ongoing household and sovereign balance sheet deleveraging, recession in Europe and slowing growth in many developed economies. Thus, risk assets may continue in their multiyear sideways, range-bound secular market, given: (i) the magnitude and duration of the previous secular uptrend (i.e., a 1,300% increase from 1982 to 2000 for US equities); (ii) significant continuing imbalances for several major economies relating to central governments’ budget deficits, indebtedness, savings, consumption, trade, currency relationships, global competitiveness, sovereign-debt quality and foreign exchange reserves; (iii) the lingering aftereffects of the severe financial and systemic recession of 2007-2009; and (iv) doubts about the timing and effectiveness of the authorities’ policy measures and voters’ response thereto.

I am sympathetic, though neither that nor their bravery in being so makes them right. That being said here are the list of bullish and bearish factors they see warring to determine the ultimate outcome:

Equities Bullish Factors

• Factors arguing in favor of equities include: (i) negative real interest rates, six central banks’ coordinated liquidity provision to funding markets, the Long-Term Refinancing Operation by the European Central Bank, and possible further monetary stimulus in the US; (ii) continued GDP growth in emerging Asia and Latin America; and (iii) policy easing and a likely soft landing in China (Morgan Stanley continues to estimate real GDP growth of 9.2% in 2011, 8.5% in 2012, and 9.0% in 2013).
• As of May 18, the consensus of analysts’ forecasts for S&P 500 calendar-year earnings per share growth is 14.7% for 2011, 8.5% for 2012, and 11.9% for 2013, according to Thomson Reuters.
• Recent consumer credit, motor vehicle sales, housing starts,and ISM manufacturing and non-manufacturing data still reflect continued expansion.
• Producer and consumer price inflation rates remain at low levels and deflation risks, while not eliminated, have faded.
• Equity 12-month forward price/earnings ratios are not excessive and the earnings yield (the inverse of the P/E ratio) is at very high levels relative to Baa corporate bond yields.
• High US corporate cash levels, which enable increased dividend payouts, stock buybacks, and mergers and acquisitions activity.

Equities Bearish Factors

• As of the end of April, US unemployment was 8.1%; the broader measure of unemployment, U-6, was 14.5%.
• Medium-term GDP growth may be held back by: (i) continuing foreclosures, home price weakness and a significant shadow inventory overhang; (ii) bank, government, and household deleveraging; (iii) state, local, and federal government fiscal austerity measures; (iv) recessionary trends in Europe; (v) decelerating growth in China, India and Brazil; and (vi) lackluster jobs growth, regional industrial production, retail sales, durable goods orders, and real personal income trends.
• Global investors and officials have continuing concerns about the quality, maturity structure, and magnitude of several countries’ sovereign debt burdens and their ability to service such obligations.
• Germany, France, several other Euro Zone countries, the UK and the US have been implementing fiscal austerity measures; absent political change, US fiscal drag will likely be significant in 2013.
• US stocks are not undervalued using long-term earnings metrics; the Shiller P/E—that is, price divided by 10-year average earnings—for the S&P 500 is 20.8, 27% above its long-term average.
• Real median household income has fallen 10% since 2007.
• Analysts’ consensus earnings estimates for 2012 have fallen 6% versus their peak and appear likely to decline further.
• In 2013, maximum tax rates on dividend income are set to almost triple, to 43.4% from 15.0% currently; on capital gains, to 23.8% from 15.0% currently; and on interest income, to 43.4% from 35.0% currently.

A good list. I will throw in that I don’t believe China will do anywhere close to as well as Morgan Stanley estimates. In fact I think the other giant BRIC, India, will do poorly as well. You can find the full report here.

• The Red Cross was founded
• Charles Lindberg landed The Spirit of Saint Louis in Paris
• My wife has her birthday!

John Hussman sees the negative market action in recent weeks as well nigh inevitable. Last night he wrote:

The Market Climate is characterized by unfavorable valuations, unfavorable market action, and a continued army of hostile syndromes that have historically been associated with unusually steep market losses over the following 6-18 month period. On a very short horizon, the market appears significantly compressed and open to a standard “fast, furious, prone-to-failure” bout of short covering in order to clear that condition.

So, he basically says that after recent declines we should see a strong bounce, followed by further declines. Right on time the market has given us at least the beginnings of a fast and the furious bounce. As for what comes next if it isn’t good don’t say you were not warned.

Barry Ritholtz weighs in on the bounce as well.

The millionaire has always been a great cocktail, but with the sudden influx of grand wealth from Facebook Fox News suggests we look to those cocktail masters at Employees Only for a proper cocktail, The Billionaire. As a confirmed fan of whiskey forward cocktails, the recipe is worth me getting in on the action:

One big hitch is that Wall Street expects to see earnings growth recelerate later this year. Notice how the yellow earnings line bumps up this summer. This receleration is hardly a given and it depends on how quickly Europe can recover.

Those are some pretty big hitches if you ask me. Here is the chart he is looking at:

I would say that the chances of that happening are very slim. Even if it does it sets up disappointing earnings for a long time after that. Throw in that Europe recovering quickly is pretty dicey, maybe even extremely unlikely. I would throw in China rolling over is a big risk as well. But hey, you need to hear the other side.

While I think that the economy is in a very fragile and vulnerable state, there are reasons to expect we may be able to muddle through. Over at Bonddad blog there has been lots of good work on that front, including on the numbers we are seeing from housing and automobiles. I would be more sanguine, but still concerned, if the issue was just one of the US economic cycle. However, the developing global slowdown may overwhelm the positives.

The Best Grilled Fish Tacos. Period. 

I keep getting requests for my opinion on Facebook. Frankly it is so far from on my radar at this point that I have nothing intelligent to say, nor any interest in forming my own opinion. Could it work out at these prices? Possibly, but it looks pretty dicey. However, I think this analaysis is not ridiculously far from what I expect I would come up with, if maybe more positive than I would be:

 “I don’t envisage, not even for one second, Greece leaving. This is nonsense, this is propaganda.”

– JEAN-CLAUDE JUNCKER, Chairman EuroGroup FinMin Committee

“When it becomes serious, you have to lie.’’

– Jean-Claude Juncker, Same guy

“Today there are in the European Central Bank, as well as in the Commission, services working on emergency scenarios if Greece shouldn’t make it. A Greek exit does not mean the end of the euro, as some claim,”

– Karel De Gucht, European Trade Commissioner

“‘Exit would bring down the whole house of cards, with one state falling after another: it would reach Portugal, Spain, then Italy and France,’’

– Romano Prodi, Former EU Commission chief

“Better to remain silent and be thought a fool than to speak out and remove all doubt”

– Abraham Lincoln

By way of a change, I am going to begin this week’s mis­sive with a joke from my youth that muscled its way into my head as I was sitting on a Malay­sian Airlines 747 about 30 seconds after take-off with flames pouring from the engine a couple of weeks ago (it truly is re­markable how the human brain functions).

I preface this joke with the now-obligatory warn­ing about political correctness (or lack thereof). The joke was told to me in the 1970s when the existence of any form of ‘PC’ was a distant pros­pect and, in those days, every country had their own racial stereotype upon who to project all their ‘dumb’ jokes; in the USA it was the Poles, in Denmark it was the Swedes (and vice versa) and in England it was the Irish (in Ireland it was the poor folk from County Kerry). As a child, I lost count of how many jokes I was told that began with the line “An Englishman, an Irishman and a Scotsman…” and, invariably, what followed was a situation that made the Scotsman look tight-fisted, the Irishman stupid and the Englishman a cunning and urbane genius. I readily admit, however, to finding reality a little different (un­less one includes trying to persuade one of my Scottish friends to buy a round of drinks…).

And so, with apologies to any of my Irish read­ers out there who are atypically easily-offended here we go:

Paddy is sitting on a plane to Dublin when the pilot comes over the PA system:

“Ladies and gentlemen this is the Captain speaking. I am afraid we have just lost power in number one engine. Fortunately, this air­craft has a total of four engines and is de­signed to be able to fly perfectly safely in the event of multiple engine failure and so there is no need for alarm – we will, however, now be arriving at our destination 30 minutes late”

There is a general murmur amongst the pas­sengers but they settle down quickly.

A short while later, the Captain’s voice is heard in the cabin once again:

“Ladies and gentlemen, this is your Captain speaking once again. I am afraid we have now lost power in number two engine. As I said earlier, we have a total of four engines and so we are still perfectly safe but I am afraid we will now be arriving at our destina­tion 60 minutes behind schedule”

A low grumble punctuated by tutting is heard from the cabin but, once again, the passen­gers settle down quickly.

Half an hour goes by and once again, the PA crackles into life:

“Ladies and gentlemen, the Captain once again. My sincere apologies but we have now lost power in number three engine. Please do not be alarmed as this aeroplane can func­tion perfectly well on only one engine, but we will, I am afraid, now be arriving 90 minutes behind schedule.”

The tension in the cabin is palpable, but once again, everybody settles down.

After another twenty minutes of uneasy si­lence has passed the Captain’s voice is heard once again:

“Ladies and gentlemen, this is the Captain speaking. I am terribly sorry to inform you that we have now lost power in number four engine…”

Before he can say another word, up leaps Paddy, who shouts “Ah sure, we’ll be up here forever now!”

What on earth does this have to do with finance I hear you ask? Well I will tell you – in a round­about kind of way. In March 2001, the Bank of Ja­pan embarked upon a program that was called ‘ry?teki kin’y? kanwa’ or, to put it another way, ‘??????’. To the vast majority of us it translated into something we are now intimately familiar with: Quantitative Easing.

Wikipedia describes QE thus:

(Wikipedia): Quantitative easing (QE) is an unconventional monetary policy used by cen­tral banks to stimulate the national economy when conventional monetary policy has be­come ineffective. A central bank buys finan­cial assets to inject a pre-determined quantity of money into the economy. This is distin­guished from the more usual policy of buying or selling government bonds to keep market interest rates at a specified target value. A central bank implements quantitative easing by purchasing financial assets from banks and other private sector businesses with new electronically created money. This action in­creases the excess reserves of the banks, and also raises the prices of the financial assets bought, which lowers their yield.

All sounds rather clever, doesn’t it? It’s not.

QE has been around in one form or another for a long, long time—a fact I was reminded of re­cently when I reread the wonderful ‘Lords of Finance’, Liaquat Ahamed’s tour-de-force, Pulit­zer Prize-winning book about the collapse of the world economy in the late-1920s (if you haven’t read it yet you truly should). I was only 75 pages in when a passage I’d read before—but at a dif­ferent time—leapt from the pages and punched me square in the face:

“…among the first casualties of war is not only truth but also sound fi­nance. None of the big wars of the previous century — for example, the Napoleonic Wars or the American Civil War — had been held back by a mere lack of gold. These had been fights to the death in which the belligerents had been willing to resort to everything and anything — taxes, borrowing, the printing of ever larger quantities of money — to raise the cash to pay for the war.

By the end of 1915, eighteen million men were mobilized across Europe. On the West­ern Front, two gigantic armies — three mil­lion men from the Allied nations and two and a half million Germans — sat stalemated, bogged down in trenches along a five hun­dred-mile front stretching from the Channel through Belgium and France to the Swiss border. Like a giant sleeping reptile stretched across the face of Western Europe, the front remained immobile. By a perverse sort of logic, as hundreds of thousands of men were led to the slaughter, their terrible sacrifice was called upon to justify pressing on, and the carnage generated its own momentum.

Still, the complacency of those first few months took a long time to evaporate. Even into 1916 the dogma that this would be a short war lingered as general after general predicted victory in another six months. By then the five major powers — Britain, France, Russia, Germany, Austria-Hungary — were spending a massive $3billion each month, nearly 50 percent of their collective GDP. No other war in history had absorbed so much of the wealth of so many nations at one time.

Countries varied in how they raised the funds. Nevertheless, there were certain common themes. To pay for such a gigantic effort by taxation alone would have entitled tax rates at confiscatory levels and was therefore im­possible. Daunted by the task, none of the governments even tried, and taxes account­ed for but a tiny fraction of the new money raised. Instead, the belligerents resorted principally to borrowing. Once they had ex­hausted every potential source of loans, they relied on a technique almost as old as war it­self: inflation. Unlike medieval kings, howev­er, who accomplished this either by shaving pieces of gold and silver off the outer edge of their coins—a practice known as clipping—or of issuing coinage made of cheaper alloys— currency debasement—governments in the Great War turned to their central banks, of­ten relying on complex accounting ruses to disguise the process. Central banks in turn, abandoning their long-standing principle of only issuing currency backed by gold, simply printed the money.”

I’ll get to the reasons for my (poor) Irish joke a little later, but right there, in those four bril­liantly-written paragraphs, Ahamed draws more compelling parallels with what is going on today than would seem possible in a little over one page of a single book and, though the book was published a mere three years ago, those paral­lels have grown eerily stronger, seemingly with each passing day.

The world IS at war, though this time the enemy is intangible. It is debt sitting in those trenches, quietly, dispassion­ately waiting for its day and that day is rapidly approach­ing as the stalemate nears its end.

Millions have been mobilized to fight the enemy through a series of ill-conceived methods, all of which have involved throwing yet more debt and more money onto the battle­field and, at each step along the way we have seen general after general predict victory and, occasionally definitively (and foolishly) claim it. It began with subprime:

“At this juncture . . . the impact on the broad­er economy and financial markets of the problems in the subprime markets seems likely to be contained,”

- Ben Bernanke, March 2007

“I don’t see (subprime mortgage market troubles) imposing a serious problem. I think it’s going to be largely contained,”

- Henry Paulson, April 2007

But then Europe took over and, though finding poorly-judged comments from just about any­body involved is like shooting fish in a barrel, I will eschew the oldies-but-goodies and pick a couple of far more recent vintage to illustrate my point.

First up, from March, Nicolas Sarkozy—one-time President of France and half of the vaudeville act known as ‘Merkozy’:

(Reuters: March 10, 2012): Mr Sarkozy, who is trailing his socialist challenger for the pres­idency before France’s own elections in April and May, pronounced the Greek deal a major success.

“Today the problem is solved,” he said in the southern French city of Nice. “A page in the financial crisis is turning.”

Another general. Another declaration of victory.

Sarkozy, however, (at least, at that time) was a politician seeking reelection. The very same day, we had a slightly more sombre assessment from Wolfgang Schaeuble, Germany’s Finance Minis­ter:

“It would be a big mistake to give the impres­sion that the crisis has been resolved. They [Greece] have an opportunity to solve it and they must use it.”

Then, after a couple of quiet months in which Greece melted away from the front pages in fa­vour of a bigger problem—Spain—the problem that never went away came back again, and this time it IS different.

Remarkably, it finally seems to have dawned on people that Greece’s exit from the Eurozone (and the euro) is a fait accompli and the process has even been given its own portmanteau in honour of the historic occasion: ‘Grexit’.

No sooner has the reality been crystallized through the application of a less-than-catchy soubriquet, than the whole world has decided it is time to weigh in on how such an event would look; the very same event that, until a few short days ago, most commentators deemed impos­sible.

I repeat my oft-uttered cry: nothing matters to anybody until it matters to everybody. Suddenly, Greece’s inevitable departure from the EU is top of everybody’s agenda.

Last week, at an extraordinary meeting of Euro­group finance ministers, it was gloves-off:

(Economist): One of the bluntest warnings came from the president of the European Commission, José Manuel Barroso, who told Italy’s SkyTG24: “If a member of a club does not respect the rules, it’s better that it leaves the club—and this is true for any organisa­tion or institution or any project.”

This was like a red rag to a bull for Jean- Claude Juncker, Lux­embourg’s Prime Min­ister and Chairman of the Eurogroup FinMin committee who fired back:

“I made it perfectly clear that nobody was mentioning an exit of Greece from the euro area. I am strongly against. We are 17 mem­ber-states being co-owners of our common currency. I don’t envisage, not even for one second, Greece leaving the euro area. This is nonsense, this is propaganda.

We have to respect Greek democracy. I’m against this way of dealing with Greece, [which consists] in provoking the Greek pub­lic opinion and giving advice and indications to the Greek sovereign. Greece has voted, we have to take into account the result. We do hope that a government will be formed in the next coming days or weeks and then we have to deal with that government. We don’t have to lecture Greece.

But the Greek public, the Greek citizens, have to know that we agreed on a programme and this programme has to be implemented. But I don’t like the way of dealing with Greece, those that are threatening Greece day after day. This is not the way of dealing with part­ners, colleagues and friends and citizens in the European Union.”

Over to Olli Rehn, Finland’s commissioner for economic and monetary affairs who, standing next to Juncker, had this to say:

“… solidarity is a two-way street. It is a fact that calls for respect of commitments both by the 16 euro-area member-states and also by Greece and its government and parliament. Without a Greek commitment this solidarity pact won’t work, and this is the responsibility of Greek politicians in this very critical junc­ture. Hence the future of Greece and the wel­fare of its citizens lie more than ever on the shoulders of Greek politicians to keep their part of the solidarity pact.”

For the first time in a long time, the unity of po­litical message coming from the powers-that-be in Europe is coming apart at the seams as the refusal to believe that economies and markets can’t be controlled by politics is wavering and the rhetoric has moved swiftly to damage-con­trol mode.

So, what exactly does the so-called ‘Grexit’ entail? Well, now that reality seems to have dawned on many, there are no shortage of forecasts amongst what my good friend Scott so perfectly terms the ‘Punditocracy’ as to what it will look like (we’ll get to that short­ly), but this past week we saw perhaps the ulti­mate break in the ranks when European Union trade commissioner Karel De Gucht opened his mouth just a little too wide and told the world what we already knew but had yet to have of­ficially confirmed:

(UK Daily Telegraph): European Union trade commissioner Karel De Gucht said that both the European Commission and the European Central Bank (ECB) were working behind the scenes on contingency plans for a break-up “Today there are in the European Central Bank, as well as in the Commission, services working on emergency scenarios if Greece shouldn’t make it. A Greek exit does not mean the end of the euro, as some claim,” he said.

As the words came tumbling from De Gucht’s lips, a Code Red was sounded in Brussels:

(WSJ): The European Economics Commission­er Olli Rehn countered De Gucht’s comments, saying: “We are not working on the scenario of a Greek exit. We are working on the basis of a scenario of Greece staying in.”

In an interview to be aired later Friday on Channel 4 Television in the U.K., Rehn also pointed out that his colleague was “respon­sible for trade. I am responsible for financial and economic affairs and relations with the ECB.”

Earlier, a commission spokeswoman denied that contingency plans for a Greek exit were under way. An ECB spokesman said in an e-mail the bank doesn’t “engage in any specu­lations about any emergency plans or possi­ble scenarios and therefore do not comment Commissioner De Gucht’s statement.”

The “immutable preference” is for Greece to stay in the currency bloc, he said, echoing comments Wednesday from ECB President Mario Draghi

Ah yes…. the ‘immutable preference’—that age-old guarantee of a preferred outcome…..

Despite the attempts of politicians to keep a lid on speculation about a ‘Grexit’ in the forlorn hope that if they don’t talk about it, nobody will worry, there have been a staggering amount of column inches devoted this week to vari­ous roadmaps for such an event. The problem, however, is that, though many of the smartest minds can offer reasoned speculation, nobody knows exactly what this will look like. What we DO know is that the first stage of it has begun in the shape of good old-fashioned bank runs:

(WSJ): Bank runs across Europe are a grow­ing fear. In Greece it appears to be the real thing. Depositors pulled 700 million euros out of banks on Monday, and Reuters reports the pace was basically the same Tuesday and Wednesday…

… It’s a very bad time to even breathe the words “bank run” anywhere in Europe.

Shares of Bankia, Spain’s fourth-largest bank and as of last week a ward of the state, were down as much as 29% today after the Span­ish paper El Mundo reported that in the past week depositors had withdrawn 1 billion eu­ros.

The report was quickly denied by the Spanish government, but the bank itself had no com­ment.

Now, whilst the smart money left Greek (and to an extent, Spanish) banks a long time ago, that is always a stealth process – it’s only at the end when the disconnected and disinterested in so­ciety finally wake up that the real panic starts and, when that happens, things tend to take on a life of their own and have far-reaching conse­quences. Take for example the consequences of increase capital flight from Greek banks to, in this case, seemingly far safer German banks.

As deposits move across Europe from South to North, they leave in their wake a big hole in the banking system from whence they came; in this case Greece. The problem comes when the Bank of Greece has to step in and reliquify the system (which it has done re­cently to the tune of €60 billion). At some point, the BoG will run out of collateral-backing and re­quire permission from the ECB in order to inject further euros into the banking system—permis­sion that will come with an implicit backing from the ECB, something it has been singularly reluc­tant to give thus far.

It is this part of the trail that leads us back to our old friend, Target2 and this week, this long-over­looked payment transfer system caught a lot of people’s attention with one of the most succinct summaries of the possible outcome coming from JP Morgan:

(JP Morgan via ZeroHedge): The Greek cen­tral bank creates euros when it grants loans to Greek banks via either repos or ELA [emer­gency liquidity assistance]. In the first in­stance, these show up as reserve holdings by the Greek banks at the central bank when the euros are credited to their account. But with euros leaving the Greek banking system, Greek banks lose reserves as transactions are settled through the payments system. As Greek bank’s reserves fall, this is replaced by a liability to the Target2 payments system for the Greek central bank. The Greek central bank’s liability to the rest of the Eurosystem via Target2 is currently near €130bn. As we move toward the Greek election next month, that is likely to climb given deposit flight. But we expect the ECB will do all within its pow­er to keep the Greek banking system afloat until the election, even if some of the loans to Greek banks are redirected via ELA. The terms of ELA can be stretched so that Greek banks do not run out of collateral, while banks can issue bonds to themselves backed by a government guarantee to create more collateral.

But a much more challenging question is what happens after the election. Let’s imag­ine Syriza is able to form a government, de­clares a debt moratorium, and antagonizes the rest of the region by rejecting the Troika programme in its entirety. Even with no fur­ther disbursements of official loans, the re­gion’s loans to Greece via the target 2 system will be continuing to grow. Loans from the Greek central bank to Greek banks would be almost completely forced into ELA.

The ECB can “shut off” the Target2 loans if it exercises its veto over ELA loans (requiring a two-thirds majority on the Governing Coun­cil), and if the Greek central bank respects that veto. But the Greek central bank would likely be faced with the need to impose very restrictive controls on Euro deposits to limit outflows if ELA loans to Greek banks cannot be made. If the Greek central bank is faced with the prospect of imposing capital con­trols, a collapse of the Greek banking system, or defying the ECB’s veto on ELA loans, what route would it take? If it chose the latter, the only way for the ECB to “shut off” the Tar­get2 loans would be to prevent Greek access to the payments system itself, refusing to ac­cept payments of euros to and from Greek banks. At that point, Greek created euros are no longer euros. That decision would not be made by the ECB alone, but would likely be deferred to European Heads of State.

Citigroup also laid out their views on the pos­sible outcomes and, the summary points alone make for a chilling read:

• There are many scenarios for a Greek exit; almost all of them are likely to be EUR negative for an extended period

• Some scenarios could be positive in equi­librium but the run-up to the new equilib­rium could be nasty, brutal and long

• The positive scenarios for the euro in­volve aggressive reduction of tail risk; none of these seem likely

• It is unlikely that central banks busily substitute EUR for USD in their portfolios during periods of intense political uncer­tainty.

So what does all this have to do with the joke with which I began this week’s Things That Make You Go Hmmm…..? Well, I’ll tell you.

As things stand, the waves of reality are finally crashing upon the shores of Europe’s own Fan­tasy Island and we are nearing the endgame.

As I have said repeatedly over the past year or so in these pages, it is only a matter of time before Greece is forced to leave the EU and abandon the euro in favour of a return to the Drachma. The rationale of trying so desperately to keep the Greeks inside the construct was flawed from the beginning as political desire was allowed to fog the simple mathematics of debt and a rigid belief that markets could be bent to the will of politicians subsumed the reality that those mar­kets care not for words, but only for numbers— numbers which have been growing ever more frightening by the day.

The only options now left for Europe are either for the ECB to assume the debts of Greece (and, once that were done, most likely Portugal, Ire­land, Italy, Spain and, one day, possibly even France), guarantee them and print the trillions of euros necessary to underwrite them or, should that prove unpalatable to the German elector­ate elected heads of the continent, allow Greece to leave and risk the contagion that such a prec­edent would set—contagion which would mean the printing of trillions of euros needed in order to compensate for the massive imbalances in the Target2 payment system and stop the entire European banking system from imploding.

Either way, somebody, somewhere is going to have to come up with trillions of euros and ulti­mately it won’t matter what the German elector­ate might think about it as they don’t go to the polls until 2013.

To that end, this week, the preparations began in earnest:

(FT): Wolfgang Schäuble, German finance minister, has given vital political cover to the Bundesbank, speaking out in support of the idea that Germany could tolerate a rate of inflation above the eurozone average.

Making a rare exception to the rule that Ber­lin does not comment on central bank policy, Mr Schäuble declared that price rises “in a corridor between 2 and 3 per cent” would be “tolerable” in Germany – slightly above the European Central Bank’s target of keep­ing average inflation across the eurozone at close to but below 2 per cent.

The oft-repeated opinion that Germans are fix­ated by Weimar-era history will surely be tested and, I suspect, found to be slightly misguided. Yes, the hyperinflation that swept across Ger­many in the late 1920s was a seminal event in the country’s history and yes, it led to horrors from which Germany is still recovering almost a century later, but in practical terms, despite the obvious reservations, it will be far easier to sell the German public on “slightly elevated inflation for a short period of time” (or “leicht erhöhter Inflation für eine kurze Zeit”—a translation you can write down because I have no doubt you’ll be hearing it very often, very soon) than the press would have us believe because Germans, like Americans, Brits and everybody else are, in the main, ignorant of the dire situation facing the global economy—and besides, 3-4% infla­tion, for a modest period, of course, is hardly go­ing to be difficult to get back under control now, is it? Just ask Mervyn King.

Just like the aeroplane that stayed aloft longer the more engines it lost, the belief that the more money that gets printed, the bet­ter the global economy will be is comical and will ultimately be proven so, but, to a politician, the pushing of an imaginary button to produce tril­lions in imaginary currency is far more palatable than imposing ‘austerity’ upon their already-agitated electorates as we have seen only too clearly in Greece these past two weeks and, if there is one thing we have been taught over re­cent years it is that politicians can be relied upon 100% in one area and one area only—the pursuit of political expediency.

Whilst fears of deflation continue to paralyze inves­tors still traumatized from 2008, what we have in ac­tuality is what Bill Murphy so eloquently calls ‘deflation in everything we own and inflation in everything we use’, a condition that will prove disastrous as politicians continue to push the same buttons harder in expectations of a differ­ent result.

Somebody, somewhere is going to have to print a LOT of money to try and make this all go away and that is the joke in all this.

Having taken my own (probably misguided) swing at humour, I will leave the final word this week to one of America’s most-underrated co­mediennes, former FDIC Chairwoman Sheila Bair, who recently took a swipe at the continued belief in money-printing being the cure for the world’s problems in a stand-up routine Washing­ton Post op-ed:

“Under my plan, each American household could borrow $10 million from the Fed at zero interest. The more conservative among us can take that money and buy 10-year Trea­sury bonds. At the current 2 percent annual interest rate, we can pocket a nice $200,000 a year to live on. The more adventuresome can buy 10-year Greek debt at 21 percent, for an annual income of $2.1 million. Or if Greece is a little too risky for you, go with Portugal, at about 12 percent, or $1.2 million dollars a year. (No sense in getting greedy.)”

“Think of what we can do with all that mon­ey. We can pay off our underwater mort­gages and replenish our retirement accounts without spending one day schlepping into the office. With a few quick keystrokes, we’ll be golden for the next 10 years.”

She was joking, right?

*************

And so to this week’s interesting reads and, as you would probably expect, they centre largely on Europe, so if the ‘Grexit’ is giving you ‘Grindigestion’ or Spain’s woes are causing you ‘Spalpitations’ then you may want to pick your way selectively through the pages that follow.

For those of you who’ve really had enough, I would recommend skipping straight to the pen­ultimate page where there is an amusing carton, but for those brave souls amongst you who have the grit (that’s not a portmanteau, by the way— just good old-fashioned grit), you’ll find several articles on Europe’s pain, some possible solu­tions and accounts of the dreadful state of af­fairs in Spain and Greece as well as an inside look at JP Morgan’s recent troubles and the booming sales of adult diapers in Japan.

Robert Reich pens a commencement address that he’ll never give, Patrick Chovanec explains the unraveling of China’s real estate market and we hear how Germany’s leaders are getting a lit­tle uncomfortable about their gold held abroad.

Our charts section focuses on unemployment, taxes, Italian and Spanish equity markets and, of course, the Facebook listing while we have inter­views with Nassim Taleb and my friend Jeremy Gray as well as another towering performance in the European parliament by the scourge of MEPs—Nigel Farage.

The full letter can be read below:

“Had I right, for my own benefit, to inflict this curse upon everlasting generations? I had before been moved by the sophisms of the being I had created; I had been struck senseless by his fiendish threats; but now, for the first time, the wickedness of my promise burst upon me; I shuddered to think that future ages might curse me as their pest, whose selfishness had not hesitated to buy its own peace at the price, perhaps, of the existence of the whole human race.”

– The musings of Dr. Frankenstein about his creation of a monster, in Mary Shelley’s 1818 novel, Frankenstein

And later the monster answers:

“Shall each man,” cried he, “find a wife for his bosom, and each beast have his mate, and I be alone? I had feelings of affection, and they were requited by detestation and scorn. Man! You may hate, but beware! Your hours will pass in dread and misery, and soon the bolt will fall which must ravish from you your happiness forever. Are you to be happy while I grovel in the intensity of my wretchedness? You can blast my other passions, but revenge remains – revenge, henceforth dearer than light or food! I may die, but first you, my tyrant and tormentor, shall curse the sun that gazes on your misery. Beware, for I am fearless and therefore powerful. I will watch with the wiliness of a snake, that I may sting with its venom. Man, you shall repent of the injuries you inflict.”

In the classic novel by Mary Shelley (written when she was just 19!), she writes about a young doctor (the Frankenstein of the title) who defies nature and creates an ungainly monster, piecing together parts that were not designed to fit each other. Even though he gives the creature life, it eventually turns on him and his family. The unhappy monster, which develops into quite the rationalizing being, demands that Dr. Frankenstein create a female version of himself so they can flee civilization and find happiness. When Dr. Frankenstein decides not to follow through on his initial promise to do so (thus the first quote), the monster seeks revenge. It does not end happily.

The European Monetary Union was a triumph of hope over reason, pieced together from very dissimilar countries which, while sharing common borders, have very different cultures and economies. That it would eventually face an existential crisis was foretold by numerous critics at the time of its creation. The euro has never been a real currency. It was and still is an experiment, fashioned and shaped by a generation with noble ideas and vision, but tied together by an unworkable structure. Can its foundation be reworked into a solid structure? Or will natural centrifugal forces pull it apart? The difficulties that are faced are somewhat akin to fixing the engine of a jet plane while it is flying at 30,000 feet.

In today’s letter we explore the options that the eurozone faces in order to stay together, and what it all means for some of the countries involved. While I have written for a very long time about the probability of Greece exiting the eurozone, the actuality is fraught with risk, not just for Europe but for the world economy. What happens in the next few months will impact us all for a very long time. Indeed, this is one of those years, as Lenin noted, when decades happen. There is a lot to cover, and in future weeks we will go into more detail, but today let’s just step back and see if we can get the larger picture.

There Is No Easy Grexit

The term du jour for the possible exit of Greece from the eurozone is “Grexit.” It is a rather ugly sounding word for what will be an ugly process if it happens. A Grexit has several serious implications. (I wonder how the Chinese translators will render Grexit.)

The first is the risk of contagion. When Bear Stearns went bankrupt, the immediate question by the market was not how much did we lose, but who is next? As it turned out, it was Lehman. The rest is history. But it was a recent lesson that is still quite vivid in the memory of traders and investors.

Grexit calls into question the very existence of the European Monetary Union. Is it a union from which there may be no exit, an “all for one and one for all” union, or is it a club that one can choose to belong to or to leave? Certainly, it’s a club that offers very distinct privileges, but also one that imposes very high costs on both the member who leaves and the members who stay, who must pick up the bar tab of the fleeing member.

There are those who argue that there is no treaty provision that allows for the exit of a member of the eurozone. Therefore, under the rules, you simply can’t leave. That is a nice concept in theory, but each member of the eurozone still thinks of itself as a sovereign country with full rights of self-determination, including the right to be self-destructive.

It is kind of like telling South Carolina in 1861 that there is no provision in the US Constitution for a state to secede from the Union. South Carolina and ten other states soon decided they did indeed have that right, and the bloodiest war in US history was fought over that question. People who think they are part of a sovereign country tend to be jealous of that idea and resist any suggestion that there may be limits on their sovereignty. And while no one thinks that the rest of the eurozone would resort to any sort of coercive action, the manner in which Greece is allowed to leave (or pushed out the door) is of the utmost importance.

The “Troika” (the European Commission [EC], the International Monetary Fund [IMF], and the European Central Bank [ECB]) has set up budgetary expectations for Greece as a condition of getting loans to pay their current operating expenses. These conditions require Greece to reduce its deficit and balance its budget by cutting government spending and raising taxes, and by actually collecting the taxes that have not been paid. This idea of not spending more than you take in taxes is called austerity by its critics and simple common sense by its proponents.

But the program has resulted in 25% unemployment (50% among youth) and a deep five-year recession, with the likelihood of another 7% dip just this year alone. (Question: How long does a recession have to last until it becomes a depression? Recessions typically last at most two years in developed countries.) Government workers are losing their jobs, and profits are severely down, as are tax receipts.

Greeks recently voted overwhelmingly for parties that want to reject the austerity program in one way or another. It was an almost complete reversal of the margins that the two previously dominant parties tended to get. Those parties agreed on the need to accept the austerity measures, in order to be able to continue selling bonds to European governmental institutions (and the IMF), since the private bond market for Greece had simply ceased to exist, except for relatively small trades by speculators buying bonds that others were forced to sell.

And the government entities represented by the Troika wanted some assurance that Greece would not continue to run huge deficits, but would at some point in the future be able to return to the private bond market. That meant that there had to be a balanced budget. Otherwise, Europe would be funding Greece for decades, which would not sit well with European voters.

Even so, because of the very real pain caused by the austerity measures, Greek voters pushed back and resoundingly voted out the parties that had agreed to the measures. Because so many small parties with such different views garnered votes, there was no way to form a majority government, and so there will be another election June 17. The recent vote notwithstanding, opinion polls show more than 75 percent of Greek voters want to stay in the euro.

There is no way to know what will happen next month; the polls change every few days. And the Greek economy may be in much worse shape by June 17. The government is running out of money to pay its day-to-day bills. We are not talking just your basic police, fire, military, and other government-worker salaries, though those are very much at risk.

The austerity deal requires that Greece actually collect taxes that are owed. One of these is the property tax, which evidently almost no one paid. And some bureaucrat got the “bright” idea (pardon the pun) to collect the tax by adding it to people’s electric bills. People tended to pay their electric bills – the power was shut off if you didn’t. However, that didn’t work out so well. This from the Financial Times:

“The government had hoped to raise €1.7bn-€2bn from the levy in the fourth quarter of last year. But a massive unions-led civil disobedience movement against this ‘injustice’ scuppered that and a ruling that it was illegal to disconnect people’s electricity supply for non-payment sent the collection rate even lower. However, the memorandum of understanding with the IMF-EU signed in March demands that Athens collects a range of back taxes, such as the property tax from 2009 which was essentially never collected. So it will be interesting to see how the Troika reacts to these most recent developments. Ironically, the scale of non-payment means that the PPC itself (the power company) has run out of money. Last month it needed a €250m liquidity injection from the government so as to avert a nation-wide energy supply meltdown. So even less of the already-too-small pot of tax revenues is going to the government. The PPC has until end of June to find new sources of funding. It seems unlikely that people who stopped paying power bills last year are suddenly going to start now. While EU-IMF funding is still forthcoming, the overwhelming support for the anti-bailout parties as Greece heads for new elections next month puts an obvious question mark over future assistance. But the PCC experience suggests we really could be moving towards the IOU stage of this crisis as liquidity issues bite.”

So let’s get this straight. Now the government is running out of money and the power company can’t collect enough to pay its bills because Greeks simply aren’t made to pay, so the government has to subsidize the power company with money it doesn’t have.

The party that leads in various polls is called Syriza. A youngish firebrand has convinced many Greeks that the austerity program must stop but that Europe should and will continue funding them. Let’s take this straight from the Wall Street Journal:

“ATHENS—The head of Greece’s radical left party says there is little chance that Europe will cut off funding to the country, and if it does, Greece will repudiate its debts.

“In an interview, Alexis Tsipras, the 37-year-old head of the Coalition of the Radical Left, also known as Syriza, warns that financial collapse in Greece would drag down the rest of the euro zone. Instead, he says, Europe must consider a more growth-oriented policy to arrest Greece’s spiraling recession and address what he calls a growing ‘humanitarian crisis’ facing the country.

” ‘Our first choice is to convince our European partners that, in their own interest, financing must not be stopped,’ Tsipras said in an interview with The Wall Street Journal Thursday. ‘If we can’t convince them—because we don’t have the intention to take unilateral action—but if they proceed with unilateral action on their side, in other words they cut off our funding, then we will be forced to stop paying our creditors, to go to a suspension in payments to our creditors.’

“According to recent opinion polls, Tsipras’ party is poised to win the most votes in repeat elections next month, bettering its surprise, second-place finish in an inconclusive May 6 vote that left no party or coalition with enough seats in parliament to form a government.”

Call me skeptical, but I fail to see how a young man who has never been at a negotiating table with any of the Troika (and who has apparently never talked with a German banker) can think he can hold Europe hostage.

“Tsipras says that, if push comes to shove, Greece can manage on its own. By not paying its debts, the country will have enough cash to pay its workers and retirees. He also proposes cuts in defense spending, cracking down on waste and corruption, and tackling widespread tax evasion by the rich.”

While such a platform might qualify him to run for US president, I somehow don’t see it convincing anyone that Greece is on a path to a balanced budget. Especially when he wants to quash the austerity programs that were agreed to, in order to secure the last round of funding.

A Rational Bank Run

The entire issue is made worse by the fact that there is a very real run on Greek banks. The FT reports that €5 billion has left Greek banks in just the last two weeks, some 3% of the total remaining deposits, by my calculation. As Mervyn King, the governor of the Bank of England noted during the Northern Rock crisis, “Once a bank run has started, it is rational to join in.”

The more that Greek citizens feel it is possible that Greece will leave the euro, the more likely they are to pull their money from Greek banks and send it abroad. Everyone in Greece is reading about the bank run, and the lines at the banks next week will be longer than the ones this week. And in today’s world there is no need to stand in line. The bank run can be entirely executed by computer. You simply open an account in another country and wire the money out.

That means the very cash that is needed by businesses small and large is fleeing the country. There is little investment in equipment or services, beyond what is absolutely necessary. Forget about getting a small-business loan at a bank. The ECB has already said it cannot continue to fund four Greek banks (talk about yelling fire in a crowded theater!), although those banks can get funded by the Greek central bank, which can get money from the ECB.

The primary resource that is needed to create growth is confidence, and that is in short supply in Greece. And if you’re in another country and thinking about investing in Greece, it makes sense to wait and see what will happen. Maybe prices of things you want to buy will be much more attractive if the banking system collapses. A few months after the collapse, someone will get around to selling the assets and loans of the banks, which may be in drachmas at the time, so your euros or dollars will go a LOT farther. Distressed loans and a currency revaluation? That smells like opportunity.

When Argentina collapsed, last decade, those who went in with cash were able to get some very good properties and deals. I could go down a list of such potential opportunities, but they will be there. At least Greek beaches are not going to be taken away. While it has been 25 years since I was there, I still remember how beautiful they were. There is a reason tourism in Greece is 20% of the economy. And that will be there no matter what currency Greece uses.

I said it was important how Europe deals with Greece, whether it stays in the euro or leaves. If Europe gives in to the demands for more money without a real plan for a path to a balanced budget, then they are sending a message to the voters of Spain, Portugal, Italy, and Ireland. Ireland goes to the polls in a few weeks. Spain already has Greek-like 25% unemployment. The frustration that Spain and the other countries feel with their own austerities is very real and getting worse, and the Troika knows it.

That is the reality that Greece faces. If they vote to stop the austerity, it is likely that Europe will simply not fund their loans. If Greece is not going to pay anyway, why not just pay off the loans or write them off? The thinking will be, “Why give them more money to spend when they are not living up to the agreements? These things can’t be negotiated with every new government. There has to be some continuity.”

But staying in the euro does not solve Greece’s most significant problem. Greece has a serious trade deficit. Its workers are not as productive as those in the core of Europe, and relative wages need to come down. And while that is easy to say in the abstract economic world, it is hard to do in the real world. What Greek worker thinks he is overpaid by 30% relative to a German worker? Try and sell that in Athens.

But that is the judgment of the market. And until the trade imbalance is solved, there will be no lasting solution to the Greek crisis. The imbalance will either be solved by a swift change of currency and a revaluation of the new drachma or a slow, tortuous process that could result in more than a decade of recessions and slow growth, with chronic high unemployment.

Greek Fatigue

Europe is visibly getting weary of dealing with Greece. Just as Hank Paulson eventually gave up trying to convince Dick Fuld to accept a rescue of Lehman Brothers on realistic terms, Europe may grow tired of being only one election away from yet another Greek crisis. And while Greeks may be tired of austerity, and they are, they have not yet come to the realization that the rest of Europe may not be willing to let them live as they want.

Greece will not be kicked out of the euro, but it is entirely possible and even likely that their funding will dry up without a continued austerity program. And that will eventually push voters to demand a government that promises them a return to their own currency. “How could it be worse?” they will think. But for a year or so it will get worse. Then it will get better. But the changes will be severe.

The Alligator of Bank Runs

If and when Greece exits the euro, the ECB must be prepared to step in with massive funding of peripheral-country banks and sovereign debt. That is not within their charter today; but when the euro is at total risk, that is the only way to save it.

As the joke goes, it is hard to remember that the original project was to drain the swamp when you are up to your neck in alligators. The “alligator” that will immediately face Europe after a Greek exit is bank runs in Spain and Italy. There must be the creation of a European-wide institution to insure deposits, in order to stop bank runs. Inexplicably, Europe does not have the equivalent of an FDIC, but if they are to survive they’d better get one.

Further, a Greek exit will mean even more defaults and losses, not only on Greek government debt but on their private debt as well. I know, the law says the contracts are in euros, not drachmas. But the Greek government will pass a law that says all debt owed by Greek citizens will be paid in drachmas, or something to that effect. And Greek citizens have to obey the law, don’t they? Exactly who are you going to send to repossess my property (car, home, equipment, etc.)? As we kids used to say when someone wanted to make us do something, “Yeah? You and what army?”

Businesses will get very concerned about doing business with citizens of a country that might leave the euro. If Greece is allowed to set a precedent by leaving, there must be clear rules for the reconciliation of contracts.

And there must be a massive show of support for Spanish and Italian sovereign debt, to convince the market that Germany and the other core countries are serious. We are talking multiple trillions of euros will be needed, if the interest rates on Spanish and Italian debt are not kept in check. That may mean the ECB will have to monetize debt for a time. Or they can change the rules and allow the European Stability Mechanism (ESM) to function as a bank, which would essentially allow the ESM to borrow from the ECB a relatively unlimited amount of capital (just 20 times leverage of €400 billion is a LOT of euros). That should buy all the time needed.

And then they have to deal with the whole fiscal union concept. As so many people said at the beginning of the euro experiment, you can’t have a real monetary union without a fiscal union. But that is a story for another letter.

So, let’s sum up. Greece will either have to continue with austerity to get any more money or leave the euro. The latter is more likely at some point, because sooner or later the voters will elect a government that will make that choice. And it may happen quite soon.

Right now, it would be difficult for the eurozone to guarantee Spanish bank deposits, for instance, and not guarantee Greek deposits. I suppose they could cook up a reason, but it would not be seen as the right thing to do in polite circles. And if a run on Spanish banks happens while waiting for Greece to make up its mind? What then? That will be a crisis on steroids.

Europe is going to either have to abandon the idea of a complete monetary union and let some nations go, or it is going to have to print massive amounts of money. Most likely it would be the ECB that turns on the presses, although making the ESM a bank could be an option if things get really bad. It all depends on how badly the Germans want to keep the euro together and what they will pay for doing so. Right now, the polls say they will do whatever it takes, even if they don’t like it. If inflation gets to 4-5%, then let’s ask the question again.

And I know some of you are thinking, how can he be talking trillions? Easy. Greece’s commitments alone to various European entities (the ECB, their portion of the ESM, EIB, etc.) run to about €500 billion. Add to that what private contract losses would be. Then realize that Greece is quite small compared to Spain or Italy. Yes, I know, Italy and Spain are not Greece; but the bond market is getting nervous. Spanish yields spiked to 6.5% at one point this week. The eurozone must commit to keeping peripheral interest rates low while countries struggle to get their budgets under control. That will not happen overnight, nor will it be cheap. It may cost Europe trillions. As in, more money than anyone can wrap their head around.

(Sidebar: I’m thinking the ECB is going to cut rates shortly.)

And the rest of the world had better hope they get it right. European banks are almost three times larger than US banks and finance much of world trade. A weakened European banking system is not good for anyone. Yes, emerging-market banks, private banks (hedge funds and sovereign funds), and even US banks can step in and, over time, make up the difference. Bu the operative words are “over time.” Building up the institutional infrastructure to finance global trade has taken decades. It wouldn’t take that long to do it again, but it would not be just a year. There could be large disruptions.

And that is not to mention European consumers and their imports, which would suffer in a prolonged European recession. Which would of course affects world trade and global GDP.

European leaders have given us an experiment called the euro. Will it be like Frankenstein’s monster and turn on them? Have they defied the natural order of Europe, or tamed the beast that raged for a thousand years? Have they created something that mankind will dearly wish they hadn’t, and suffer for their hubris?

Or will the euro yet become a Hercules, capable of performing astounding feats for the greater good? We are at the critical moment of the experiment, when the results are not yet clear but everyone can see that we won’t have to wait much longer.

Who Gets the Old Maid?

A popular card game for children is called Old Maid, which is played with a deck with an extra queen. The cards are dealt and the players trying to match their cards (a 3 with another 3, or a king with another king, for instance) until they can play all their cards. And of course you must trade cards with other players. When one person has no cards left, whoever has the Old Maid (the solitary queen) loses. There is some strategy involved, as if you have the Old Maid early, you might not pass it until close to the end, so it cannot come back to you.

Which brings to mind the balance sheet of the ECB, and leads to some rather dark thoughts. If Greece leaves, then at best the ECB will only get drachmas in return for the euros on the Greek account. IF Greece decides to pay anything at all. (My bet is that if they do pay, there will be strings attached that say the ECB must hold the drachmas for a very long time, so as not to hurt the currency.)

OK, but that increases every remaining eurozone member’s commitment by around 2.5% of the remaining balance. And then what if Portugal or Spain leaves? Or, heaven forbid, Italy? Your commitment just grew by a rather large amount. Not to mention your portion of the ESM, EFSF, EIB, etc.

On the way to a Nash equilibrium, the players all try and anticipate the moves and rationale of the other players, plus what their levels of pain tolerance will be. And then they adjust their own positions.

At what point does it occur to the voters of a country that they are taking on more debt than they can bear? How much European solidarity is really there? Is there an unlimited amount of pain that can be tolerated? I rather think there is a limit; we just don’t know what it is, or even if we could ever conceivably get there.

At what point does a country decide it does not want to be stuck with the Old Maid? Will Greece be allowed to walk away from its commitments? And if it tries, what will be the consequences? I know there is no mechanism for any of this, but someone had better be doing some serious planning around it, because you can bet a lot of investors are privately calculating how things will play out. This can all be handled, if you decide to deal with the issues openly.

So what am I worried about? We all know that developed countries do not default on their sovereign debts: the banking regulators of Europe have told us so. And if you can’t trust a banking regulator to know what he’s doing, then who can you trust?

Atlanta, New York, Philadelphia, Italy, and Singapore

I leave for Atlanta Tuesday and get back Thursday morning. I am then home for a whole ten days before I take off to New York for a meeting and then on to Philadelphia for the CMG Advisor Forum with my good friend Steve Blumenthal. He has assembled an outstanding group of speakers. Details to follow, but if you are an investment advisor you should consider coming. You can call CMG at 610-989-9090.

I have a few other events on the calendar, but the next big trip will our third-annual vacation to Tuscany. I do love Tuscany and am looking forward to seeing friends and relaxing a little bit. Then in July I will be going to Singapore for a speaking engagement, and will try and see more of that country. I really liked it when I went earlier this year.

And speaking of Frankenstein, I think Mary Shelley wrote the first true science-fiction novel, creating a whole new genre of literature. She took what was known as science (or at least scientific lore) and extrapolated into the realm of “what if,” giving us a tale that called into open discussion the nature of life and existence. And to do that while still a teenager? When today our students write papers in English classes that leave us wondering about what we allow to pass for literacy in our educational system?

This has come to mind while watching a YouTube video about my friend David Brin’s new book which, almost 200 years after Mary Shelley, deals with the very same issues, but with a very modern twist and cutting-edge science. The book is titled simply Existence, and it will be out in June. A Science Fiction Hall of Fame writer, David weaves a great story while making us think about the purpose of life. You can see the video (about 4 minutes) at http://youtu.be/cn6GqxeOvn4

It is once again time to hit the send button. It is early Saturday morning and I need to get some rest to prepare for another action-packed week of trying to figure out the ontological meaning of the existential angst in Europe that is caused by the dilemma of Greece. Or, in layman’s terms, “What the hell are they thinking?”

Have a great week.

Your happy to be existing at very this moment in time analyst,

John Mauldin

John@FrontlineThoughts.com

Jim Hamilton looks at Joseph Kennedy’s claim that speculators are the cause of high oil prices.

meanwhile Venezuela under Chavez puts in place price controls to keep food prices down. Result? Food shortages. Who could have predicted that? The belief that price controls (whether floors or caps) on labor, capital, services or goods won’t cause shortages on one side of the equation or the other is frankly mind boggling, but nevertheless pervasive. Floors lead to shortages of demand (the minimum wage) caps lead to shortages of supply (food price caps.) Argue the benefits outweigh the costs (rarely true if ever) but it is foolish to deny the impact.

How Pixar almost deleted Toy Story 2

Education Is the Key to a Healthy Economy

Josh Brown sees a depressing pattern emerging:

Right about now is the time where the fabled Second Half Recovery™ shows signs that it’s not going to take place.  Right about now is the time when Wall Street strategists and economists begin ratcheting down GDP estimates and tempering their optimistic year-beginning calls with a dash of bitters and a dollop of doubt.

Just like last summer.  Just like the summer before.

Read the details, but we have noticed that analysts had earnings slowing (as was inevitable) and then showing a hockey stick like recovery as the year ended as well. We have seen mid and late cycle earnings hockey sticks before. As far as we recall they have never materialized.

Tyler Cowen looks at the problem of structural unemployment during the 1930′s. Krugman is likely unimpressed.

Over at Bloomberg Jonathan Weill finds Jamie Dimon’s ignorance of what goes on at his own bank scary. Maybe so, but let us be clear. Our financial difficulties partly stem from a gap between the finance geeks and the finance suits. The suits, of whom Dimon is an exemplar, do not understand what the geeks are doing or warning about. That isn’t their skill set. Frankly, when it comes to a bank like JPM, the true exposure and risk levels are beyond anyone’s real comprehension as I pointed out in the Fall of 2008 in JP Morgan, Lehman and Nightmares:

I am often asked about individual bank stocks, especially JP Morgan. Generally my answer is that Bank of America, JP Morgan and a few others look to be likely survivors, but how profitable they will be I am really unsure.

JP Morgan is a special discussion, because I point out a rather astonishing fact, they have a notional exposure to around 90 trillion in derivative contracts, or did last March (pdf.) 58 trillion of it swaps of some sort. Probably credit default swaps (CDS) are the majority. Which means…what? I don’t know, and frankly if anybody really does they aren’t telling me. In essence I am left telling people that I have to treat that as a “black box.” Not exactly confidence raising. Personally there are better ways to make money than hoping a company with 90 trillion in derivatives exposure has a handle on it in my book, but then again, I am admitting that I have no idea what I am talking about, and cannot find anyone else who does either.

Warren Buffet often speaks of defining a circle of competency when investing and staying inside it. It doesn’t matter how big the circle is, just knowing when you are inside it. Well, 90 trillion in derivatives exposure is outside of my circle of competency to assess.

The nightmare is what if it is outside of JP Morgans circle? I suspect it is, and the massive exposure of two other banks as well (Citibank and Bank of America have approx. 38 trillion apiece.)

James Montier gave a widely admired speech at the CFA conference on “The Flaws of Finance.” You can see the speech here and below is the accompanying essay:

Jeff Matthews gives us his notes on the latest Berkshire Hathaway annual meeting.

We have been of the opinion that the risk of a significant slowdown in China was much higher than the consensus believed. Recent data is certainly not encouraging and Gavyn Davies for one is becoming more concerned, as are markets.

Of even more concern is we are not sure that official statistics in China remotely align with reality, and the Financial Times bloggers show why. Frankly, the official story out of China doesn’t add up.

Edward Harrison is convinced Greece will exit the Euro. The question is, “will it be a voluntary or involuntary exit?

The Economist’s Charlemagne’s Notebook likewise sees Europe groping towards Greece leaving the Euro. In the piece the current head of the Eurozone finance ministers makes the impolitic remark that Greek voters have a, well, vote:

We have to respect Greek democracy. I’m against this way of dealing with Greece, [which consists] in provoking the Greek public opinion and giving advice and indications to the Greek sovereign. Greece has voted, we have to take into account the result.

However, that has been our point (or at least one of two main points) all along when it comes to the Euro project. It is inherently incompatible with the idea of democratic freedom within a group of sovereign nations. If the market believes voters can thumb their noses and even vote to leave, then the market will price in the risk of default accordingly. As discussed previously we don’t have that issue here in America because we decided the issue of secession in 1865. Barring a wilingness to send in the troops to stop a Greek (or any countries) exit or the formal and irrevocable unification of the respective nations, currency unions are inherently unstable. Here is what we pointed out last Fall:

3. Full Fiscal Integration: Since all other solutions put in place circumstances that are unstable and merely kick the can down the road, the fundamental flaw in the Euro needs to be addressed. That is the lack of a unified fiscal policy. The answer then is the end of sovereignty, the creation of a US of Europe. An obvious objection is that Germany wants to be a sovereign nation. We’ll skip this niggling little detail, but even if they didn’t want to remain sovereign do they want to harmonize laws and economic policy with Greece and some of the other PIIGS? West Germany just  integrated with East Germany and the experience was traumatic featuring massive transfers to East Germans. The PIIGS will still not be competitive with Germany. That means internal adjustments (internal devaluation or austerity) to allow them to become more competitive for the PIIGS’ or massive transfers. Thus unifying the Eurozone under a single fiscal policy means massive transfers from Germany to the PIIGS to harmonize the welfare states and unify the debt and avoid austerity throwing the entire Eurozone into depression. Germans will pay for the debt in one fashion or another.

Cullen Roche points out that in the US we don’t worry much about the need for internal transfers between states to keep the system sound.  Today that is true, though it has led to large conflicts in our past, playing a role in civil unrest, uprisings, the conquest of a continent and near destruction of its former inhabitants and the Civil War. Our unity was easier to envision and still born of blood and tragedy.

I am not saying unification of Europe would lead to such tragedies and conflicts. However, we need to ask if Germany (or really all the countries) want to make the internal transfers that make such a system work? Germans would pay a great deal, Greece and the other PIIGS would suffer internal austerity to the extent that they contribute to the economic re-balancing. Do Europeans, or most importantly the Germans, view themselves as a people who will be responsible for paying all the bills to integrate the Greeks and others?

Are Europeans ready to think about their home countries in the same way Texans think of Texas? Their state, but completely subordinate to the US? Will they be able to secede? We answered that question in the US with a war of incredible savagery and destruction. My guess is a unified Europe would be far less stable. They will not choose a civil war comparable to the US, but instead countries leaving over time as well as never entering the union. That leaves us with all the problems we have now still being there. Without a European populace overwhelmingly in favor of a true union this will not work. We would be faced with a PIIGS like crisis with every election and the possibility of secession in each of the former countries.

I want to emphasize that I do not think Spain is hopeless. Rather, it has a narrow set of limited options that will require a great deal of austerity and economic pain on the part of Spain and significant help from the rest of Europe, combined with the forbearance and patience of the bond market or massive buying of Spanish bonds by the ECB for an extended period of time. I think it will need to be the latter, as the bond market is on the brink of breaking down on Spanish debt, failing a realistic path to economic balance and growth. The way ahead is most difficult and treacherous. It appears to me that at the end of the day only ECB participation can buy Spain the time it needs. If they give Spain the time, it can get through. But the pain will then be spread to the valuation of the euro and thus the entire eurozone.

Is a new fiscal compact a possibility? One with nations giving up control of their budgets and a euro-wide bond issue by which all the nations guarantee the others’ debt? Or is there some middle option? Anything is possible and everything will be discussed, as the cost of a eurozone breakup would be massive.

This week’s Outside the Box shows some of the reasons why the task is so daunting. Not to mention Italy. And the election results in France suggest a new government may be coming in May, whose leader has promised to renegotiate the recent eurozone agreement, although the details of what that really means are quite murky. And of course France is only a few years from its own crisis, if its deficit is not brought under control. Hollande has said no more austerity yet has not proposed a plan that promotes real growth.

We will soon plunge into yet more last-minute crisis meetings and summits, in which will be hatched yet more “plans.” The German Bundesbank will complain about ECB largesse, but they don’t control the ECB, as they once thought they did. They are toothless. But any pan-European plan that requires more German pledges (taxes and debt) must get through their legislature. And the Bundestag is most definitely NOT toothless. Can Merkel tame them once again? It will be difficult if the ECB ignores the Bundesbank warnings. You can only push so much.

A very narrow and treacherous path indeed. And it wends all through Europe, not just Spain.

I write this on my iPad from the train to Philadelphia, as I have managed to fry my computer. Somehow, the coffee spilled on the keyboard this morning did not seem to do it any good. Oh well. I get a backup laptop tomorrow. No data lost, just time and money. Sigh.

Your feeling like a rookie traveler analyst,

John Mauldin, Editor
Outside the Box

JohnMauldin@2000wave.com

Debt/Income/Productivity

The standard of living of the average American continues to fall. Real median household income today is near the same level as it was fifteen years ago, a remarkable statistic since the debt to GDP ratio is 100 points higher (Chart 1). The cause of this deterioration in living standards can be traced to the excessive accumulation of debt, as well as the debt proportion that has turned increasingly unproductive, or even counterproductive. When debt is utilized to finance nonproductive assets, an economic process is initiated that undermines prosperity. Productivity gains must be generated in order to boost income, and thereby the standard of living. If debt enhances productivity, incomes will expand and the economic pie will be enlarged. Otherwise, the debt increase exercise is debilitating to economic growth.

The negative feedback loop arising from the unproductive nature of this debt accumulation is straightforward. First, United States government spending carries a zero expenditure multiplier, as do operating expenditures of state and local governments. Thus, each dollar spent by the federal government creates no sustainable income, yet the interest payment incurred with each borrowed dollar creates a subtraction from future revenue streams of the private sector. Second, much of the massive debt increase over the past decade has been in the form of mortgage debt. Jobs and income were created with the expansion of the housing stock. However, no productivity gains are evident in this housing stock increase, which means future incomes have not expanded. Nevertheless, the repayment of principal and interest weighs down the system, and the consequences of delinquency, foreclosure, default and bankruptcy compound the problem.

Third, debt that is utilized to finance consumers’ daily needs obviously fails to generate any productivity or future income growth. Efforts by fiscal and monetary authorities to sustain growth by further debt accumulation may produce some short-term benefit. Sadly, these interludes fade quickly as the debt becomes more destabilizing. The net result of increased indebtedness then becomes the opposite of what policymakers intend when they promote economic growth by either borrowing funds for increased government expenditures or encourage consumers to borrow with artificial and temporary incentives.

Modern Example of Over-Indebtedness

Since 1989, Japan has provided an excellent but highly disturbing example of the debilitating effects of a prolonged period of taking on additional debt while shifting more of the debt into unproductive uses. In 1989, their public and private debt was just under 400% of GDP. After repeatedly trying all of the Keynesian and monetary school recommendations on a large scale, Japan’s debt ratio stood at an all-time record 491% in 2011. Over this 23-year span, the portion of government debt to GDP ratio more than quadrupled, advancing from near 50% to over 200%. The government’s financing needs were so great that the private debt to GDP ratio actually contracted nearly 55%, a strong indication that the composition of the debt increasingly financed unproductive activities. Since 1990, numerous episodes of seemingly better Japanese growth failed to establish a self-sustaining recovery as debt’s negative feedback loops progressively worsened.

The trajectory of the Japanese experience is beginning to take shape in the United States. Since 2009, private debt to GDP has declined while government debt to GDP has surged. If we use the IMF projections for gross U.S. federal debt for this year and next, and assume that the private debt ratio is stable, the total debt to GDP ratio will rise sharply this year, and again in 2013, putting the U.S. in Japan’s footsteps (Chart 2). Also, the U.S. economy has witnessed episodic improvement along with gains in business and consumer confidence. But, ephemeral positive shifts in psychology cannot match the negative elements of higher levels of unproductive debt.

Previous Debt Episodes

The U.S. accumulated a massive amount of unproductive debt in the 1920s. The ultimate solution to that episode was a period of austerity in which the saving rate soared. Significantly, the Japanese personal saving rate from 1989 to 2010 exhibits a completely contradictory pattern to the U.S. experience from 1929 to 1950. During that period in the United States, the excessive debt of the 1920s was dramatically reduced and created the basis for post WWII U.S. prosperity (Chart 3). From 1989 until the early 1990s, the Japanese saving rate was consistently above 25%, but in recent years it has fluctuated around zero as the debilitating effects of ever high debt levels have accumulated. The mandatory rationing in the United States during World War II, combined with the income generated gains in exports of virtually everything we could produce from U.S. farms, mines and factories pushed the U.S. personal saving to a peak of more than 25%. This permitted the excessive debt of the 1920s to be paid down. The current low level of U.S. saving precludes the same resolution to the debt problem seen in the 1920s case, but is similar to the current Japanese situation.

Bang Point

There is a longer-term negative feedback loop that has been referred to as the “bang point” by economists Reinhart and Rogoff, and it occurs when government or private borrowers are denied access to further credit because the marketplace has no confidence that new or existing debt can be repaid. At this point interest rates soar and debt issuance becomes impractical; therefore, the government or private borrower is forced to live on current revenues. As recent cases in Europe have documented, this is painfully disruptive, with high social costs. We do not believe this point is at hand for the United States, but it has occurred many times historically, including in contemporary Europe. If it were to happen in the U.S. now, the consequences would be traumatic since 42 cents of every dollar spent by the federal government in the first six months of the current fiscal year was borrowed. The chaos that would be created by a reduction in federal government spending of 42% is unimaginable.

Disequilibrium

Economic models, regardless of whether from micro or macroeconomics have two conditions: equilibrium and transition. In the simplest micro model like the market for soft drinks, equilibrium is reached when the supply and demand curves intersect and determine the price of the item and the quantity demanded and supplied. When either the demand or supply curves shift, this transition leads to a new equilibrium. Equilibrium occurs at a specific point in time. This simple model also yields total dollar sales or the quantity supplied or demanded, multiplied by the selling price. When aggregate demand and supply curves intersect, the aggregate price level, real GDP and nominal GDP are determined at a specific point in time.

The economics profession has almost universally taught that equilibrium is the main condition and that transition is short and largely trivial. Little effort is made to trace the critical role of the transition process. However, the sweep of economic data over the last hundred years suggests that transition is a much longer phase than equilibrium. Economies only attain equilibrium briefly, if at all, before moving on to another period of transition.

Tracking Debt Disequilibrium

The distinction between equilibrium and transition is well illustrated by the private debt statistics available since 1916. Over this 96-year span, private debt to GDP averaged close to 160%, or 130% below the level for 2011. The private debt to GDP ratio moved into close proximity or crossed its mean no more than ten times (Chart 4). Obviously much more time has been spent in transition than at equilibrium. A similar economic indicator, velocity of money, demonstrates the same pattern.

The velocity of M2 (V2) had only ten equilibrium points from 1900 to 1953 and from 1980 to the present. From 1953 to 1980, V2 was stable around the post 1900 mean of 1.68 (Chart 5). Periods of stability should not be surprising since debt and velocity are linked. When increases in debt are of the sound variety, such as the normal type of business and consumer lending in traditional banking, velocity should be stable. When debt to GDP accelerated very rapidly after 1980 along with a great increase in financial innovation, velocity surged until hitting a post 1900 peak of 2.12 in 1997. After 1997, velocity turned down, indicating the surge in debt was going into less productive uses. Such a pattern was exhibited in the 1920s when the debt to GDP ratio surged, but V2 fell. Other series with very long historical records, like the price earnings (P/E) ratio, the cyclically adjusted P/E ratio and the real 30-year Treasury bond yield, confirm that equilibrium is the rare condition. Transition is the norm, and that transition is extremely volatile and erratic.

In 2011, the U.S. private and public debt to GDP ratio was about 174 percentage points higher than the post 1870 average. Comparably measured debt to GDP ratios are substantially higher in the Euro zone, the UK, Japan and even Canada, indicating that the debt issue is a global depressant to growth. To remove this growth impediment, debt needs to decline dramatically relative to GDP for a prolonged period. Contrary to common wisdom, monetary and fiscal policy actions that spur growth by increasing debt may buy transitory gains in some measures of economic activity, but they perpetuate this disequilibrium. Increasing debt merely makes the economy more vulnerable to economic weakness and potential instability because income growth is stunted or, as previously stated, over-indebtedness cannot be cured by more debt. Periods of over-indebtedness change the sacrosanct rules of thumb of business cycles. The conventional wisdom of business cycle analysis that suggests five to seven good years followed by one to two bad years is broken. Normal risk taking is not rewarded.

Impact on Investment Returns

The current period of extreme indebtedness in the U.S. constitutes the third such episode since the Civil War. The two earlier cases include the 1860s and early 1870s, and the 1920s and 1930s. After these previous massive debt buildups, two twenty-year periods ensued where the total return on the S&P500 was less than the total return on long-term Treasury bonds, a condition referred to as a negative risk premium. The underperformance of stocks relative to bonds from 1928 to 1948 occurred even though WWII intervened. Extreme over-indebtedness created a different playing field from normal circumstances that did not reward risk for a very long time. Once the excessive indebtedness was corrected, a positive risk premium was reestablished. The risk premium was also negative from 1991 to 2011.

Thus, if the U.S. economy is unable to deleverage, then the already long cycle of an abnormal, or negative, risk premium will be extended. A negatively correlated asset, such as long-term Treasury bonds, will continue to generate positive returns, while serving to minimize the volatility in a diversified portfolio.

The Pathway Out of Excessive Indebtedness

From both economic theory and historical experience the answer is clear; austerity is the solution to too much debt. McKinsey Global Institute examined 32 cases where extreme leverage caused financial crises since the 1930s. In 24, or 75% of these cases austerity was required, which McKinsey defines as a multi-year and sustained increase in the saving rate. Public and/or private borrowers took on too much debt because they lived beyond their means, or they consumed more than they earned. Thus, to reverse the problem spending had to be held below income, increasing the saving rate. In eight, or 25% of these McKinsey cases the problem was solved by high inflation, but none were major global economies and all were emerging markets with either no central bank or a very weak one. It should be noted that some of these cases involved massive currency devaluations, an option that is not open to the United States or the other major highly indebted economic powers.

Devaluations were tried repeatedly from the late 1920s until World War II during an episode referred to as “beggar thy nation” policies. These devaluations only produced temporary gains for individual countries because retaliatory devaluations ensued. In those days, the world was on the gold standard, so it was possible to devalue, whereas today all major currencies except the Chinese Yuan float freely, or relatively so. That period was before the world understood the Nash Equilibrium, named for the Nobel Prize winning economist John Forbes Nash. Nash’s equations demonstrate that if one party takes an action unilaterally for its own benefit then the overall benefit to all parties will decline.

Many people, including the majority in the political arena, consider austerity to be an unpalatable option. The Japanese policy makers have rejected this solution for more than two decades as their saving rate has declined from almost 25% to nearly zero. But, if the McKinsey data and economic theory are as valid as we believe, then the sooner the reality is accepted the sooner the economic norm can be restored. Taking on more debt, the current course of action, only serves to delay the restoration of prosperity. In other words, more debt can boost the GDP growth rate for a short period of time, but the GDP growth rate cannot remain elevated, and increased indebtedness serves to further undermine the standard of living.

Inflating Away Debt

Even though history demonstrates that inflating away debt has occurred only in small nations with unusual circumstances, this option remains a point of concern in the United States. We continue to believe that a deflationary environment is more likely to prevail than an inflationary one for several reasons. First, attempting to create higher inflation would mean that our debt to GDP ratio would only grow more onerous. In the U.S., debt is about four times the size of GDP. The increase in interest rates associated with higher inflation would be one for one according to well-tested empirical results and economic theory. However, GDP would lag because real incomes would fall short as the cost of living would rise faster than income for most Americans. Demand for higher wages might prevail in time but full relief would be lacking for a broad section of employees. In addition, a downward bias on wages would exist from import competition. Second, the rising rate structure would decimate discretionary expenditures at all levels of government. Deficits would increase as the interest on the debt would be increasing faster than revenues, and would replace all discretionary expenditures in a very short period. At the end of the day, more debt and increased interest payments would translate into lower productivity, lower income, and higher unemployment. To start down this road of inflation would be foolish, impractical, and improbable.

Bond Yield Developments

In early April the Fed announced that there were no plans to embark on a new round of quantitative easing. Initially, the announcement was greeted negatively in the Treasury bond market, as evidenced by rising yields. Our analysis indicates that the Fed’s decision should be viewed ultimately as a constructive development. The ending of QE1 and QE2 caused investors to shift from inflationary sensitive assets into longer-dated Treasury securities as the economy slowed, and inflation quickly subsided once the Fed’s balance sheet stabilized. This prior experience indicates that the current upturn in inflation and the related rise in bond yields is likewise transitory.

Since the end of last quarter, the 30 year Treasury bond yield has risen to a high of 3.5% in March. In most years economic optimism seems to flourish for the first four or five months of the year. Seasonally, interest rates are usually at their yearly highs between late February and mid May. In fact, in fourteen of the last twenty years the thirty-year Treasury bond yield has peaked in the first half of the year. Our view remains that while interest rates can rise for many transitory reasons, underlying economic fundamentals suggest long-term rates cannot remain elevated and will gradually move lower.

This week we take a brief pause in our series on the choices facing the developed world to look at some items that are catching my attention. We will get back to the US next week, as somehow I think we will not solve our problems between now and next Friday, and there will be plenty left for us to talk about. So today we look at the “shift” in Fed policy, and at the balance sheets of central banks, US GDP, Portugal and the ECB, the LTRO policy, and yes, there’s even a tidbit on Greece. Plenty of ground to cover, so with no “but first,” let’s get started.

The Transparency Trap

The Fed announced this week that it will keep rates low until 2014. Interest rates responded by getting even flatter. This policy change has caused a lot of negative press, for some good reasons, but I want to offer a somewhat different take on their motives.

Telling us that rates will stay low for another three years has a lot of negative implications. First, it says that the Fed does not expect a recovery of any significance during that time (more on this week’s GDP numbers further on). Second, it tells any individual or business that there is no reason to hurry and borrow money to get lower rates. You can wait and see how things turn out before you decide to act.

Comstock Partners minced no words in their scathing criticism:

In our view the Fed’s new policy is an act of desperation rather than something to celebrate. The FOMC has used all of its conventional weapons and a lot of unconventional ones and is essentially out of ammunition. The banking system is swimming in excess reserves that it is not using—-adding more won’t make much of a difference. This is a classic liquidity trap where further easing will not be much help. The stock market strength assumes that the economy is getting stronger and that company earnings will remain at elevated levels. We think that this will not be the case, and that the market is subject to substantial downside risk.

I agree with their sentiments and conclusions, but I think the Fed is in more than a liquidity trap. For lack of a better term, let’s coin one and call it a “transparency trap.” The Fed and the FOMC do not create their policies in a vacuum. The individual members talk to business leaders at length every week, and their staffs are also seeking out opinions and reactions. While they may not talk to you and me, they are aware of the reactions to their positions. Let’s take that as a given. These are not men and women who are easily pushed into a position. They get where they are by being able to forcefully take a position and push for their policies. We may not like their positions, but they put some thought and a lot of work into making them. Frankly, it is a damn hard job. No matter what they do, they will make a lot of people upset. And this week is a case in point.

Ben Bernanke has been quite open in that he wanted a more transparent Fed. He wanted explicit inflation targets long before he joined the Fed. He wanted more communication and openness from the FOMC. Many in the media and elsewhere lauded those sentiments, including me, as the more we know about their thought process, the better we can all plan.

However, there were others who said that the Fed needed to keep theirs cards closer to their chests. Showing too much of their inner reasoning could mislead as well, as policies could change and the Fed should not feel locked into any one position if the underlying circumstances shifted. There should be an element of mystery, they maintained. Some former members of the Fed were very outspoken in their desire to not increase the transparency of the Fed. As with sausages and laws, we simply do not want to know too much about what goes into making Fed policy, they asserted

But slowly, Bernanke has put his stamp on the Fed, including his views on transparency. His speeches and presentations are far more comprehensible than the foggy pronouncements of Greenspan. He has started doing press conferences. And with this meeting, he has persuaded the 17 members of the FOMC to offer projections about the economy – in this case, where they think rates will be for five years into the future.

The headlines talked about the Fed keeping rates flat into 2014, but if you look at their median forecast, they expect rates to rise by all of 0.5% at some point in 2014. And for the record, here are the rest of their more significant forecasts:

The Fed knocked down its forecast of economic growth a few notches for the entire forecast period (see table below). The Fed sees the economy growing around 2.2%-2.7% in 2012. The Blue Chip consensus forecast of growth in the US is 2.2% on an annual average basis as of January 2012, while the IMF projects growth of 1.5% for the United States in 2012 on a fourth quarter to fourth quarter basis.

The central tendency of the unemployment rate for 2012-2014 was lowered but the longer run projection was left intact. The unemployment rate is expected to be around 8.2% to 8.5% by the end of the year, which is different from the Blue Chip consensus of 8.5% (determined by a survey taken prior to the publication of the December employment report, most likely to be revised down). Inflation is projected to below the Fed’s target of 2.0% until 2014. With regard to inflation, Bernanke formally indicated that 2.0% inflation is the Fed’s target rate and this rate as being consistent with the Fed’s dual mandate. (Asha Bangalore, Northern Trust)

All in all, not a very upbeat group. Given their views, it is no wonder they expect rates to stay low. And thus we have the transparency trap. They are now telling us what they really think, something that most people in most places wanted only a short while ago. And we see the 17 individual forecasts, so we can get a sense of the range of opinion, which is quite wide, actually. Look at the following graph, which shows us when the members of the FOMC expect rates to finally begin to inch up.

Note that six members expect rates to rise within the next two years and four expect rates to be flat into 2015, with two members thinking rates will not rise until 2016. And over whatever they define as the “longer term,” they expect the Fed Funds rate to be 4.25%. (Which causes me to mangle that song from the children’s movie classic, Snow White: “Some Day My Price Will Come.”)

(You can see all the projections in glorious detail at http://www.federalreserve.gov/monetarypolicy/fomcprojtabl20120125.htm . )

Tell Us What You Think We Want to Hear

If we want to know what they think, and they tell us, are we then going to shoot the messenger? We asked, they delivered. If they gave us those projections and did not change their interest-rate projections from the last meetings, they would be subject to ridicule, because they did not say in the statement what they really believed.

In a very real way, they were forced to say they expected rates to be flat for 2-3 years. To say anything else would have been rather pointless, at best, and subject to even more intense criticism at worst. Once they opted for transparency, they were forced to take the position they did. Put this in the category of “be careful what you ask for, because you may get it.”

Now, take note. And I do not mean this as a specific indictment of Fed economists and forecasters. This goes for all of us who dare venture a thought about the future.

There is a natural tendency to take current conditions and project them forward. Which is why stock analysts who forecast earnings are so predictably bad. And the all-star team of blue chip economists (in the US) have yet to predict a recession, even when one has started, let alone in advance! Once you rely on models, you are doomed to error. I have read studies that show analysts are not even as accurate as one would expect from simple random selection.

I think we should take these Fed projections as more of a curiosity, for at least the next two years. In two years we will have 16 data points (8 meetings a year) which will show us some of the evolution of their thinking, and that will be very interesting.

For what it’s worth, if someone had asked me, I would have said that rates will be flat for a very long time. We inhabit a deflationary, deleveraging reality. That suggests lower inflation. I have written at length why unemployment will be higher than we are comfortable with; it is just a product of the current environment and simple math. To see unemployment come down we need to see growth in the 3.5% range, and our next topic will show us why we are not even close to that number.

A Very Soft GDP Number

GDP came in at 2.8% for the 4^th quarter of 2011. That is a respectable headline number, given that the US economy only did 1.6% for the whole of last year. For those who look at this number as half full, I offer the following observations. First, examine GDP growth for the last few years. The 4^th quarter has been much better than previous quarters, and then GDP dropped off again.

The 2.8% number is softer than it looks. Two-thirds of that growth (1.9%) was from inventory build-up (standard accounting practice says that growth in inventory increases GDP, while sales of inventory reduces it). “Real final sales (GDP less inventory changes) expanded at an anemic 0.8% annual pace in the fourth quarter, a sharp slowdown from the third quarter’s healthy 3.2% rate. That paints a different picture from the apparent pick-up in headline GDP growth from the third-quarter’s 1.8% yearly rate. The difference reflects the shift to inventory building in the fourth quarter from a drawdown in the third quarter.” (Barron’s)

I suppose one could spin inventory growth as businesses being optimistic about future sales and building inventory, but given the weaker retail sales of late (in comparison to previous years) that is rather doubtful. And so all that really happened was a total reversal of inventory sales in the previous quarters. There will be a drawdown of inventories over the next few quarters, which will be a drag on future GDP numbers, much like the pattern we have seen the past few years.

Retail sales growth was not strong. And for the last year, 90%-plus of total retail sales has come from decreased savings, as the savings rate dropped from 4% to 2%. It will be hard to go much lower, so the “boost” we got last year from retail sales accounts for most of the year-over-year growth in GDP. If most of retails sales growth came from reduced savings, that suggests that retail sales will not offer much in the way of growth for the coming year. Just saying.

Further, when calculating real GDP, one subtracts inflation. The Fed prefers an inflation measure called PCE (Personal Consumption Expenditures). It is essentially a measure of goods and services targeted toward individuals and consumed by individuals. The number you read in the various media is the CPI or Consumer Price Index. The CPI is inflexible, in that it’s always the same basket of goods. PCE on the other hand, is supposed to take into consideration the notion that if steak is too costly, we’ll eat hamburger. The CPI is typically 0.3-0.5% higher than the PCE, which is convenient if you want the GDP number to look better.

The Fed changed to PCE in February of 2000. The change was buried in the footnotes of the annual Humphrey-Hawkins testimony by then-Fed Chairman Greenspan. So the anemic growth of 1.9% for the last decade would have been even worse if we had used the previous measurement of inflation (CPI). Understand, there is an argument in favor of using PCE, as many academics argue that CPI actually overstates inflation. But there is also an argument to use CPI. It somewhat depends on what you want the final numbers to be.

Fast forward to today, and the year-over-year change of CPI was 2.5%, with the PCE only rising 1.7%. And last quarter was down sharply, to +0.04% on an annual basis. An anomaly of lower energy and commodity costs? Partially, for sure. So if their target rate of inflation is 2%, using PCE gives the Fed grounds for a looser monetary policy.

All in all, GDP was helped by numbers that are not likely to repeat. For a long time I have maintained that the US economy is in a Muddle Through range of around 2%. I remember when last year at this time we had estimates of 4-5% growth for 2011. I looked so bearish. Now, not so much, as 2% would have been better than what we got.

I think we will be lucky to Muddle Through again this year. Mind you, if it was not for a potential shock coming from a serious European crisis and real recession, the US should not slip into outright recession this year.

Central Banks: A High-Wire Balancing Act

I got this note from bond maven (and Maine fishing buddy) Jim Bianco (courtesy of Barry Ritholtz). It made me sit up and take notice. He compared the balance sheets of the four largest central banks (the US, Europe, Japan, and China) and then four European central banks (Germany, England, France, and Switzerland). There has literally been an explosion in all their balance sheets. Interestingly, China has seen the largest growth. And where is the inflation that one would expect from all the monetary printing? You can see some of it in China, but not anywhere else.

Jim points out that central bank balance sheets, when taken together, have spiked recently in relationship to total world stock market capitalization. He concludes with these thoughts:

What Does It All Mean?

“2011 was so difficult because all stocks seemingly moved together. It was as if every S&P 500 company had the same chairman of the board that knew only one strategy, resulting in a high degree of correlation between seemingly unrelated companies.

Massive central bank involvement in the markets risks returning us to a de facto centrally planned economy. Those S&P 500 companies all have the same chairman; it is Ben Bernanke because his policies are affecting everybody. That is what makes money management so difficult. Correlations will ebb and flow; they always do. But what makes them go away? This will only happen when governments and central banks go away.

But if they go away, then does that not mean things get ugly? Maybe they do get ugly, but it also means that we sort out the excesses in the market. We reward the people that do the right thing and we punish the people that do the wrong thing. And we have an adjustment process that may be ugly, but then we have a period of long expansion.

Central banks are ruling markets to a degree this generation has not seen. Collectively they are printing money to a degree never seen in human history.

So how does this process get reversed? How do central banks pull back trillions of dollars of money printing without throwing markets into a tailspin? Frankly, no one knows, least of all central banks as they continue to make new money printing records.

Until a worldwide exit strategy can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of central bank balance sheets. As long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise.

When/If these central banks go too far, as was eventually the case with home prices, expanding balance sheets will no longer be looked upon in a positive light. Instead they will be viewed in the same light as CDOs backed by sub-prime mortgages were when home prices were falling. The heads of these central banks will no longer be put on a pedestal but looked upon as eight Alan Greenspan’s that caused a financial crisis.

The tipping point between balance sheet expansion being bullish for risk assets versus bearish is impossible to know. Given the growth rate of central bank balance sheets around the world over the past few years, we might not have to wait too long to find out. Enjoy it while it is still bullish.

You can read the whole piece at The Big Picture: http://www.ritholtz.com/blog/2012/01/living-in-a-qe-world/

A Few Thoughts on LTRO

The ECB is taking almost any quality asset a European bank offers up and putting it on its balance sheet, as part of its long-term refinancing operation (LTRO). Basically, this allows a bank to post an asset at the central bank and receive 1% money, which they can turn around and use to either improve their own balance sheet and liquidity or buy European sovereign debt at, say, 6%. If the bank then makes 5% on the loan and leverages it up, it can “get whole” in a short time.

This is the same principle (in theory) that Paul Volcker used in 1980 when he allowed US banks to carry the debt of defaulting Latin American countries at face value. Given enough time and interest-rate spread, a bank can work its way out of a problem. And it worked for Volcker. Eventually, US banks made enough money to be able to write off the bad debts.

While this is a band-aid, an attempt to cover up the real problem of banks that are basically bankrupt and sovereign countries that are either in default or at risk of default, it is so far proving to help. Germany has essentially thrown in the towel on keeping the ECB from printing money. While they still growl and bark, like any well-trained dog they stay in the yard. They are a big dog, and their barking makes you nervous as you walk past, but so far they are allowing the ECB to prop up banks throughout Europe. On that point at least, Sarkozy won.

As long as LTRO continues, it should postpone the problem of a true banking crisis – until Portugal has to default, and then all eyes turn to Italy and Spain. If the ECB is allowed to fund Italy and Spain, even through the back door, it will mean Germany has made its choice to keep the euro intact, no matter the cost.

Greek Exhaustion Syndrome

One of my very good friends had a small private dinner this week with the chairman of a major German bank, who remarked, with a sense of gallows humor, that he thought he could get his fellow German banks to chip in enough money to give to Greece to just make them go away. They really have Greek Exhaustion Syndrome.

He also thought Portugal would eventually would have to leave, and said he thought he would take a haircut on Irish debt. Italy and Spain will somehow make it. At least that is the view from the top of the German bank pyramid.

Portuguese interest rates are soaring. Without life support from Europe, they cannot keep up their borrowing at rates that will allow them to recover. While they are gamely trying to reduce their deficit, austerity is reducing their GDP and thus their tax revenues. They will have no choice but to default at some point.

The interesting case is Italy. They have room in their budget to cut, as I have outlined in prior letters. If the ECB subsidizes their debt (lowering the interest-rate cost) or an agreement is reached to lower the rate on their bonds, they theoretically could make it. But either path is default by another name. Maintaining the status quo is not possible. It will not be long before they are at 130% debt-to-GDP, if Europe falls into recession. The IMF has long maintained that 120% is the line in the sand.

It is just a matter of who pays and how the payment is made. But someone will pay.

And there’s this note for those who think austerity comes with few consequences. From the Centre for European Reform:

Eurozone policy-makers – from President Sarkozy and Wolfgang Schäuble to the former President of the ECB, Jean-Claude Trichet – advocate that Italy and Spain should emulate the Baltic states and Ireland. These four countries, they argue, demonstrate that fiscal austerity, structural reforms and wage cuts can restore economies to growth and debt sustainability. Latvia, Estonia, Lithuania and Ireland prove that so-called “expansionary fiscal consolidation” works and that economies can regain external trade competitiveness (and close their trade deficits) without the help of currency devaluation. Such claims are highly misleading. Were Italy and Spain to take their advice, the implications for the European economy and the future of the euro would be devastating.

What have the three Baltic economies and Ireland done to draw such acclaim? All four have experienced economic depressions. From peak to trough, the loss of output ranged from 13 per cent in Ireland to 20 per cent in Estonia, 24 per cent in Latvia and 17 per cent in Lithuania. Since the trough of the recession, the Estonian and Latvian economies have recovered about half of the lost output and the Lithuanian about one third. For its part, the Irish economy has barely recovered at all and now faces the prospect of renewed recession.

Domestic demand in each of these four economies has fallen even further than GDP. In 2011 domestic demand in Lithuania was 20 per cent lower than in 2007. In Estonia the shortfall was 23 per cent, and in Latvia a scarcely believable 28 per cent. Over the same period, Irish domestic demand slumped by a quarter (and is still falling). In each case, the decline in GDP has been much shallower than the fall in domestic demand because of large shift in the balance of trade. The improvement in external balances does not reflect export miracles, but a steep fall in imports in the face of the collapse in domestic demand.

Portugal and Greece are on that path, if they do not opt out of the eurozone. Italy and Spain cannot avoid the sad results of too much debt without major European support, which means the ECB, as no country will offer that amount of help, as none has the money to do so. But that means a lower-valued currency and purchasing power, higher energy and commodity costs, etc. As I keep saying, it is not a matter of pain or no pain, it is simply a choice of which pain and how much of it you want to have.

It is interesting to watch the game being played with Greek debt (merely interesting, because I have no Greek debt). Private bond holders are now looking at only getting about 30% on the euro. They are now asking that the ECB share some of their pain, and the IMF seemingly agrees that the ECB should. The ECB is aggressively resisting any such notion. An interesting principle is being set here. If you do it for Greece, then the line will get much longer. The euro is on its way to parity with the dollar, as I have said for a very long time.

Those predicting the death of the dollar (at least against major world currencies) and hyperinflation do not understand the rather vicious nature of deflation and debt deleveraging. But that is a topic for a later letter.

Ah, but what do we have here, at 3:36 AM (via my London partner, Niels Jensen), but an article by Nick Doms on Examiner.com, asserting that, yes indeed, Greece will default:

Greece plans an orderly exit out of the Eurozone according to two sources close to Mr. Papademos, Greek Prime Minister, who spoke on condition of anonymity earlier today.??The sources confirmed that plans are ready to return to a legacy currency given the current circumstances and that such exit would be dealt with, quote ‘in as orderly a fashion as possible’ unquote….

A Greek exit strategy will probably not be announced officially until early March when the EU finance ministers meet.

Well then, we shall see.

Cape Town, Stockholm, Geneva, Paris, and London

What a week. Neil Howe (The Fourth Turning) came in at the last minute for a quick dinner with old friends Barry Habib and David Galland of Casey Research (among others). What a thought-provoking night. And the next night Bloomberg hosted a small dinner with some of the hedge-fund mavens here in Dallas and Fort Worth, and I was part of the entertainment. I learned a lot in the free-for-all give and take. No shy types at that table.

I leave for Cape Town, South Africa for a very short trip in ten days: I’ll give a speech and turn around the next day and come back. Then I am home until the middle of March, when I go to Stockholm for another speech, then to Geneva for a day for some quick meetings; and then I will either come home on the weekend or stay in Paris to attend the Global Interdependence Center’s conference on central banking. That promises to be a very lively and vigorously debated theme, and a lot of good friends will be there, so there will be a nice spirit of bonhomie for springtime in Paris. I don’t go to many conferences as a participant, but this one is the topic du jour. Think about joining me. (http://www.interdependence.org/programs/inaugural-meeting-of-the-global-society-of-fellows/ ) And maybe London, since I’ll be in the neighborhood.

This has been an especially busy week, with some very important events. We officially launched Mauldin Research Trades, which will be marketed by Bloomberg. I am thrilled to have such a solid relationship with one of the premier names in the financial world. MRT is only available through Bloomberg. It is designed as a service for institutional and other large trading funds. Basically, we have brought together 14 of the world’s best technical traders, over a broad expanse of markets, to develop very specific ideas based on my macroeconomic views. We hope to average 3-4 trades an issue, along with updates. My good friend, business partner, and mortgage-market expert Barry Habib is heading this up. If you are interested, contact your Bloomberg representative.

Then we also came to an agreement with another firm to expand the publishing side of my business, which will actually free me up to do more of what I like to do, which is to read and research and write my letters to you. I am quite optimistic that we will be able to do more for you, which is my #1 goal.

Other positive changes are coming as well, which I will announce in the future. In the meantime, it is time to hit the send button. Once again it is late, but I will sleep in tomorrow. Have a great week. Mine will be good, as Rich Yamarone, Woody Brock, and Mark Yusko come in for a dinner on Tuesday, and then we do the Dallas CFA forecast dinner on Wednesday evening. What fun!

Your am I having fun or what analyst,

John Mauldin

John@FrontlineThoughts.com

One Of The World’s Best Bellwethers Just Demolished Earnings And Announced A Stellar 2012 Outlook

We are earnestly looking for reasons to make us think that the roller coaster ride to nowhere that global markets have ridden since April of 2010 might end, so I dug in to the article.

What is this global bellwether? Caterpillar. What does bellwether mean?

A bellwether is any entity in a given arena that serves to create or influence trends or to presage future happenings.

This gets me to one of my pet peeves about much market commentary. Claims are asserted as true or meaningful without ever investigating whether it has any validity. Stocks are cheap arguments are allowed without any evidence being provided that the method used works! Data that has no predictive value for the economy is assessed as if it does and sources that have no historical record of assessing the economic future accurately are treated as reliable indicators.

One source of economic forecasting that we should generally ignore when it comes to recessions are corporate projections. I often hear Jim Cramer and others say that to understand where the economy is heading the CEO’s and executives of our leading corporations are on the ground and in the know. I beg to disagree. Corporations are pretty good at forecasting their own earnings a quarter or two out as long as we do not have a recession. They are useless in forecasting recessions however, and thus economic and market risk. So what does Caterpillar say and let us see if maybe they are the exception.

First of all they had a great year, and they did. So, things must be great.

As for next year:

In general, prospects for economic growth have improved over the past quarter, and we expect the world economy to grow about 3.3 percent in 2012, a small improvement from about 2.8 percent in 2011.  In response to economic concerns, some central banks began easing policies late in 2011.  Underpinning our growth expectations for 2012, we expect this easing to continue and contribute to the improvement in growth.

Key points related to our economic outlook include:

• We expect improving world economic growth to increase demand for commodities.  Our outlook assumes most commodity prices will increase slightly in 2012 and continue at levels that encourage investment.  We expect that copper will average over $4 per pound, Central Appalachian coal about $75 per ton and West Texas Intermediate crude oil about $100 per barrel.
• In the developed economies, capital investment recovered much faster than did overall economies.  This better performance occurred primarily because businesses had improved cash flow and better access to credit.  In addition, businesses let capital stocks depreciate significantly during the financial crisis of 2008 and 2009.  We anticipate business investment will continue to outperform other economic sectors in 2012.
• We expect the U.S. Federal Reserve will maintain the Federal Funds rate below 25 basis points throughout 2012 and will not reduce the size of its balance sheet.  U.S. banks have record high capital ratios and considerable funds to lend.  We expect bank lending in the United States, which increased during the second half of 2011, to continue to grow in 2012.
• Recent economic data suggests that U.S. economic growth improved in the fourth quarter of 2011, which we believe reflects the positive impact of Federal Reserve easing that was initiated in late 2010.  The full impact has likely not materialized yet, and we expect economic growth will improve further in 2012.  Our outlook assumes economic growth in the United States of at least 3 percent in 2012.
• We expect total U.S. construction spending, which, net of inflation, has declined since 2004, to finally begin to recover in 2012.  We project a 1.5-percent increase in infrastructure-related construction and a 5-percent increase in nonresidential building construction.  We are expecting housing starts of at least 700 thousand units in 2012, up from 607 thousand units in 2011.
• While U.S. economic activity is improving, the recovery has been slow by historic standards, and unemployment remains high.  If economic growth does not accelerate, it may take several years for unemployment to reach pre-financial crisis levels.  In our view, this would signal the potential for a prolonged period of continued growth in the United States.
• The Eurozone public debt crisis has been a lingering negative, but it is unlikely to trigger a worldwide recession.  The Eurozone will likely have at least two quarters of weak, possibly negative growth, but should begin to improve in the second half of 2012.  For 2012, our outlook assumes economic growth for the Eurozone near zero and growth of about half of a percentage point for Europe in total.
• Our expectation for improvement of European growth in the second half of 2012 rests on a continued easing by the European Central Bank (ECB).  The ECB has recently lowered interest rates and could cut rates further in 2012.
• More importantly, the ECB increased its balance sheet more than 35 percent since July 2011 to improve banking system liquidity.  Other European central banks have been taking similar actions.
• Business investment in both the Eurozone and the United Kingdom has grown faster than the overall economies and is a trend we expect will continue.  Businesses have improved cash flow and need to upgrade capital stocks.
• We project the Japanese economy will grow 3.5 percent in 2012, recovering from a 2011 recession.  Rebuilding from the tsunami and more expansionary central bank policies are expected to drive the recovery.
• We expect economic growth in Asia/Pacific will exceed 6.5 percent in 2012, about the same as in 2011.  Growth should improve in Australia and Indonesia, the result of recent interest rate cuts.
• China took its first easing action in late 2011, and we expect that further easing is likely.  We expect China’s economy will grow 8.5 percent in 2012, sufficient for growth in construction and increased commodity demand.
• Growth in Latin America is expected to slow from 4.3 percent in 2011 to about 4.0 percent in 2012.  Our outlook assumes interest rates will be flat to lower in most countries.  We expect that economic growth will be sufficient for construction spending and mining output to increase.
• Africa/Middle East will likely benefit from low interest rates and favorable commodity prices.  We expect the regional economy will grow nearly 5.5 percent and that construction spending will continue to improve.
• We expect the CIS economies will grow more than 5 percent, and construction spending will increase more than 15 percent.  Favorable factors include low interest rates, higher metals and energy prices, and increased production of oil, gas and metals.

As with any Economic Outlook we believe certain aspects are worth considering, and suggest you do so. However, does Caterpillar qualify as a bellwether? Should we give their opinion and economic outlook any credence as opposed to the poor record of economic forecasting from major corporations in general? Let’s test by looking at the last recession. That recession (if not its magnitude or exact characteristics) was the most obvious and telegraphed recession possible, yet most forecasts  missed it. Did Caterpillar? Here is the January of 2008 version of today’s release. Unfortunately I haven’t located their outlook earlier which would be more relevant, but in reading this remember that the US was already in recession when this was written:

U.S. economic growth:  We forecast the economy will grow 1 percent in
    2008, slow enough that the National Bureau of Economic Research may
    eventually decide that a recession occurred.  We expect construction will
    likely remain distressed in 2008.  If the Fed continues to cut interest
    rates as we expect and the U.S. government takes action to stimulate
    economic growth, 2008 could be the bottom of this U.S. machinery cycle.

    U.S. housing:  Housing starts should slow from 1.35 million in 2007 to
    1.1 million in 2008.  We expect continued downward pressure on the
    industry from a large inventory of unsold homes, tighter lending
    standards, increased home repossessions and lower home prices.

    U.S. nonresidential construction:  New contracts awarded should decline
    more than 4 percent in 2008, continuing a weakness that developed in the
    last half of 2007.  Negatives include tighter lending standards, reduced
    corporate cash flows, rising vacancy rates and a smaller increase in
    federal highway funding.

    U.S. coal:  This sector showed some improvement in fourth quarter 2007,
    and further recovery should occur in 2008.  We expect the recent rebound
    in coal prices and increased coal exports to drive the turnaround.

    European interest rates:  Financial markets are unsettled in Europe, and
    we expect this will prompt the European Central Bank to hold interest
    rates at 4 percent for the rest of the year and the Bank of England to cut
    interest rates again to 5.25 percent.

    European economic growth:  Our forecast is for 2.3 percent growth in 2008,
    down from 2.7 percent in 2007.  Both nonresidential building and
    infrastructure construction should improve, however housing declined in
    2007 and should do so again in 2008.

    Developing economies:  The robust recoveries in these economies should
    last throughout 2008.  Our forecasts are for 5.5 percent growth in
    Africa/Middle East, 7 percent in the CIS, 4.5 percent in Latin America and
    7.5 percent in Asia/Pacific.  Those growth rates are close to those of the
    past two years and should encourage further growth in construction.

    Metals mining:  World demand for metals should increase, and inventories
    remain tight.  We expect prices for most metals will remain attractive for
    new investment.

    Oil and Gas:  The world's spare oil production capacity remains low, and
    oil prices should average higher in 2008.  Higher prices should drive
    increased exploration, drilling, pipeline expenditures and tar sands
    development, which should benefit both machinery and engine sales.

    Electric Power:  Rapid growth in oil producing and commodity exporting
    nations should drive generator set demand.  Increased business investment
    in Europe should benefit demand for standby power.

    Marine:  Demand should benefit from increased world trade and favorable
    freight rates.  Shipyards are already contracting for 2009 and later
    berths.

Verdict? By January, after the recession had already begun Caterpillar sees at worst a shallow recession in the US and strong global growth and record profits for them. The specifics miss by a mile and they completely whiff on the global economy. I don’t mean to pick on Caterpillar either. This is a problem for economic forecasting in general, and we shouldn’t expect them to do any better than they do. Standard economic forecasting models are fine most of the time, but fail at modeling recessions. To add to these models factors that might help in recession forecasting makes them less useful in general. Here is the track record of mainstream economics:

Source: GMO

Not exactly inspiring.

Which doesn’t mean that looking to the future is pointless. General economic regimes can be identified. Leading indicators can be assessed as long as you are rigorous in assessing whether they truly are leading indicators. Risks can be identified.

In general predictions of recession cannot be made with a great degree of confidence (2007-2009 being an exception in my mind) but identifying that a recession is more likely than usual can be done. True leading indicators (see John Hussman’s recent discussions) are flashing danger signals, even if not proof positive that a recession is imminent. That we are in a typical post financial crisis period when weak growth and elevated recession risk is present should have been the consensus since the recovery began. We may not know everything, but there is ample evidence of what we should have expected in general, even if most of Wall Street and economists ignored history for their typical models and assumptions.

All of that should have led to a reduction in risk taking by prudent investors once the rally in equity markets became stretched in terms of valuation heading into 2010. Certainty isn’t necessary to act prudently, just a reasonable idea of potential risks versus potential reward. Luckily, a broadly diversified portfolio has not fallen off a cliff yet if you missed the opportunity to reduce risk so far, but that is not a given if the global economy rolls over, China slows substantially or Europe starts to break apart.

This week we look at a report called “Working Out of Debt,” about debt and deleveraging, from the McKinsey Global Institute. This is a well-done summary of their longer paper, which has been updated, called “Debt and deleveraging: Uneven progress on the path to growth.” I discussed the original paper both in my regular letter and in Endgame. It is one of the best, most definitive pieces on the topic I have read. For those trying to understand how the deleveraging process will affect their particular world, I think it is a must-read. I have been spending more and more time thinking about the whole process of deleveraging, and am coming to think deleveraging is the critical and fundamental factor shaping the economic environment and impacting every decision countries and businesses are faced with. This paper was done by Karen Croxson, Susan Lund, and Charles Roxburgh; and they are to be especially commended for their insight and work.

This summary and the full report look at the relevant lessons from history about how governments can support economic recovery amid deleveraging, and at the signposts business leaders can look for to see where economies are in that process.

Overall, they tell us, the deleveraging process has only just begun: “During the past two and a half years, the ratio of debt to GDP, driven by rising government debt, has actually grown in the aggregate in the world’s ten largest developed economies. Private-sector debt has fallen, however, which is in line with historical experience: overextended households and corporations typically lead the deleveraging process; governments begin to reduce their debts later, once they have supported the economy into recovery.”

You can sign up at their website and see the full report at https://www.mckinseyquarterly.com/Working_out_of_debt_2914. I would strongly recommend you do so, not only for this report but because their website is chock full of well-done articles on a wide variety of topics, and they update it frequently with more material. It is all top-notch. It is worth visiting just to see what they have done in areas that may be of more specific interest to you, or because like me you are an information junkie and want to keep up on a wider world than just macro-economics.

Have a great week. Mine will be busy but interesting, which is always good. And this Friday I start a series on the choices that we face in the US, so there will be lots to ponder amidst the noise.

Your wondering how the Giants got into the Super Bowl analyst,

John Mauldin, Editor
Outside the Box

JohnMauldin@2000wave.com

(James Dailey serves as the lead portfolio manager for TEAM Asset Strategy Fund and as TEAM Financial Manager’s chief investment officer. Today’s post originally appeared at their bl

I laid out in my 1/13 blog post how we were amending out outlook a bit relative to recession recognition and the potential for risk markets to suffer sometime over the next couple of months once a recession was recognized. We’ve been relying upon leading economic indicators to help us create a narrative to what markets are “speaking” to us – i.e. that a significant cyclical bottom was put in from August through October of 2011. As I always try to remind myself and others, one of the cornerstones of our investment process, which is geared to embracing that markets are random and chaotic, is that intellectual flexibility is paramount. I pride myself on trying to make sure we prioritize making money way ahead of being right.

At the risk of being drafted as a Republican presidential candidate, I will now lay out how we are flip flopping around on our outlook like a fish out of water. In case you cannot tell by now, our conviction level in a specific narrative as to why markets are unfolding as they are is modest. The scenario I laid out in the 1/13 post still seems to be plausible, but we think an alternative scenario also makes sense.

What if we already had a recession and the economy has already troughed and is in the early stages of a cyclical recovery? Such a question may seem absurd at a time when the vast majority of economists and strategists are crowded in one of two camps, with most arguing the US will avoid recession altogether and the other arguing that a 2008 type abyss lays directly ahead. We’ve never shied away from throwing out scenarios that seem absurd relative to consensus!

Gross Domestic Income (GDI) has trended down for 6 straight quarters and is the typically ignored sister report to Gross Domestic Product (GDP). The US Fed has done a study which shows that GDP has typically been revised over time to move in line with GDI. GDI was basically zero during the 3rd quarter of 2011 and we’ll get 4th quarter government data by the end of January. Something GDI and GDP share is that they are reported in real terms using government generated inflation statistics. As I’ve commented on for years now, government calculated inflation statistics have become a joke, as there has been an explicit campaign to understate inflation in order to try and cut entitlement benefits like Social Security. There have been two major changes over the past 30 years, and there is a new bipartisan movement currently underway to change the calculation once again as part of “budget reform.”

The specific inflation number used in the GDP report is called a deflator, which is different than the consumer price index (CPI) in some ways – and mostly in showing lower inflation. But to keep things relatively simple, I’ll use the CPI for the purposes of this post. The US government has reported a CPI for 2011 of 3.2%. When the government reports GDP of say 2%, that is in real terms. One would need to add the 2% plus the inflation rate, 3.2% in this instance, to get nominal GDP growth. Obviously, the inflation figure plays a huge roll in this calculation.

If the government were still reporting CPI as it did prior to the Boskin Commission changing things in the 1990′s, it would have been over 6% for 2011. If nominal GDP were to be 6% for all of 2011, this would mean that real economic growth ex inflation would basically be zero! In reality, that is about what I think happened in 2011. For example, in Q2, GDP and GDI were reported to have been 1.3% and 0.2%, and Q3 were reported at 1.8% and 0.2%. These were official numbers using current inflation calculations. If one were to assume real world inflation was actually 2%-3% higher than reported, that would have resulted in GDP of negative 1-2% during the 2nd and 3rd quarters and possibly around zero for the 4th quarter when it is announced. GDI would have been in the negative 2%-4% range, which certainly fits with the terrible consumer sentiment over that period.

This is all just an intellectual exercise, but I believe it does open a question as to whether an economic contraction in real terms (using realistic inflation rates and not trumped up government statistics) did occur sometime starting over the summer, with a trough occurring sometime between September and now. It is possible the current cycle may not result in the formal declaration of a recession by the government, as they are using phony baloney data.

Market Dynamics

The scenario I lay out is another that makes sense to me given how financial markets and coincident economic data have unfolded in recent months. Risk markets made what I described to be classic cyclical bottoms in August and October of 2011 and have been progressing since with classic cyclical dynamics. Early cycle sectors like housing, transports, financials and industrials have assumed market leadership in recent weeks. Government bonds in the US and Germany have begun to trade very weak recently, as interest rates have begun to head higher. Riskier currencies have begun to outperform, with emerging market currencies assuming leadership once again. European bank stocks have launched to the upside, much as US banks did during the spring of 2009. Commodity markets appear to have stabilized and begun to trend higher. The Chinese stock market appears to have finally exhausted to the downside – at least for now.

As we consider this backdrop, we believe it is prudent to continue giving risk markets the benefit of the doubt for now. Having said that, we are growing increasingly concerned that a correction/retracement of significance is likely to unfold at some point before Q1 ends. A 5-10% correction would be normal within the context of a cyclical recovery. Sentiment has become quite bullish in recent weeks and markets rarely reward excessive optimism without first sending a shockwave with which to endure. However, unless we see a significant shift in how markets are moving, we expect to maintain a bullish cyclical bias.

Finally, if the Fed and other central banks add additional stimulus into the scenario I’ve laid out in this post, it could be like adding lighter fluid onto an already burning cyclical fire. I think such a development could make precious metals and commodities explosive positions for the remainder of 2012.

“If we want everything to stay as it is, everything will have to change.”

– from The Leopard by Giuseppe Tomasi di Lamedusa

“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought, and that’s sort of exactly the Mexican story. It took forever and then it took a night.”

– Rudiger Dornbusch

Europe’s leaders are committed to keeping both the euro and the eurozone as it is. But for it to do so, everything must change, as the wonderful quote from the 1958 Italian novel suggests. This is no easy task, as no one wants a change that will impact them negatively; and there is no change that will allow things to stay the same that does not impact all severely, as we will see. In the third part of a continuing series, we look at the actual options that are available on the menu of choices, or as one group called it, the menu of pain. I offer some guideposts that we should watch for along the way, and end by offering a suggestion as to what Europe should do. As has been the case in this series, I do my best to offend everyone at some point. If by some small, unintended oversight I do not, then wait another week, I will get to you. What else are friends for?

But before we take on Europe, let me quickly tell you to save the date for my annual Strategic Investment Conference, co-sponsored with my partners, Altegris Investments. And what a lineup we have this year. Already scheduled are my friends Dr. Woody Brock, Mohamed El-Erian, Marc Faber, Niall Ferguson, bond-fund star Jeff Gundlach, Dr. Lacy Hunt, David Rosenberg, as well as your humble analyst. And there are a few more blockbuster names we are close to finalizing. Most people who attend think this is simply the best investment conference of the year, and I think this one looks better than ever. It will be May 2-4 in the San Diego area. I will soon give you details about where you can go to register, but for now put it in your calendar. What better way to think about how to invest in these times than to hear some of the best minds in the world, all in one place?

As this letter will suggest, I don’t think this is the year you want your portfolio in typical long-only funds. There is a lot of tail risk this year coming from Europe. For those who are accredited investors and interested in alternative investments like hedge funds and commodity funds, which can help you navigate through these volatile times, let me suggest you go to The Mauldin Circle and register, and my friends at Altegris Investments will give you a call. I am finishing up a new Accredited Investor Letter, and they will send it to you for free as our way of saying thanks for talking with us. Now, let’s jump right in.

Choices, Debt, and the Endgame

We started off this New Year’s series by pointing out that the choices we make today are constrained by the choices we made in the past, and the choices we make in the future will be limited by the choices we make today. Europe chose to create a free trade zone, and then some of the countries proceeded to lock themselves into the gold standard of a single currency, relinquishing the ability to adjust any imbalances in their economies by changes in the prices of their own currencies.

Interest rates for the southern tier of Europe dropped to levels never available to them before, and those countries responded by borrowing ever-increasing amounts of money to finance current spending. Then came the credit crisis, and budgets simply ballooned out of control, and debts began to get to levels that made the bond markets ask for ever-higher rates, as concerns about sovereign defaults began to rise.

This problem was compounded by the fact that European banking institutions were allowed to leverage their purchases of sovereign debt by 30 or 40 to 1 their actual capital. That means even a default by a small country has potentially big ramifications. As it became clear that Greece was in trouble, European leaders at first thought that if Greece was given some time, it could get its budget deficit under control and then once again gain access to the bond market.

In the summer of last year, after dithering through some 40-odd summits, it began to dawn on European leaders that it was not a short-term liquidity crisis they had on their hands but a solvency crisis. A fact that numerous commentators had been pointing out to them for quite some time. And as Greece began shake and bake its way to “austerity,” the very act of cutting deficits pushed the country into recession, which lowered tax revenues and increased expenses, putting the elusive goal of a balanced budget even further off. We should quickly note that this is not just a Greek problem. Spain’s “draconian” cuts have meant that its 6% deficit target for the year has this week been raised to a more likely 8%, making it harder to get back to even.

For country after country, this is the Endgame. It is the end of the Debt Supercycle. Debt has grown to the size that it cannot be sustained. The market will not lend any more money on terms that can be afforded, and any efforts to cut spending and raise taxes will result in an even worse economy, in various degrees of recession, with falling revenues and rising costs.

Europe has three main problems.

1. A growing number of its countries are insolvent or close to it. It is increasingly likely that the only way forward is for defaults of some type, to lessen the burden of debt to a level where it can be dealt with and that will allow the countries the possibility of growth, which is the only real answer to the problems they face.

2. Because of growing fears of multiple defaults (just Greece would be bad enough!) most of the banks in Europe are seen to be insolvent and in need of hundreds of billions of euros of new capital. The interbank market in Europe is in a shambles, and banks park their cash with the ECB, at a lower rate of return, as that is the only institution they trust. They clearly do not trust each other. As an aside, I heard from many sources while I was Hong Kong and Singapore, meeting with readers and friends, that European banks (especially French) are cutting back on their trade lending, which is making normal commerce more difficult. Didn’t we just go through that in 2008?

3. The real problem in Europe is the massive trade imbalances between the peripheral countries and the so-called core countries. Without the ability to adjust currencies, those trade imbalances will render any debt solution moot, as a country cannot balance its budget while it runs a trade deficit and its citizens and businesses also deleverage. I have written about this arithmetic problem on numerous occasions. There must be balance or there must be a mechanism to achieve balance.

One cannot solve one problem without solving all three. Either they all get done or none truly get done. You can kick the can down the road by solving problems 1 and 2, but problem 3 will put you shortly back to square one.

Europe is now trying to address problems 1 and 2. They are talking about a “new treaty” that will require austerity of a real kind, although I understand that Germany has put in a clause that gives it some extra time to achieve its own balanced budget. And the ECB is dispensing euros through the back door to banks, in exchange for anything resembling collateral. Not directly of course, as that is prohibited, but the same thing is being accomplished, despite objections in some quarters, mostly German.

Staring Into the Abyss

It was late in September of 1998. I was flying from New York to Bermuda to speak at a hedge fund conference, and found myself upgraded at the last minute, back in the day when I did not fly that much, so I was feeling rather happy. As the door closed, a patrician-looking gentleman stepped in and came and sat next to me, immediately picking up a file and burrowing into it. I had a book and the Wall Street Journal, so I was content to read.

As soon as we took off, he asked for a scotch. He proceeded, over the next hour, to wage a very aggressive war on the diminishing cache of scotch bottles stored on board. (No, it was not Art Cashin. He doesn’t fly.) It was an arduous campaign, but he was fully committed to winning.

He glanced over to my Journal and noted some headline about the crisis that had occurred the previous week. I had been following the extreme market volatility with interest, but this was in the first decade of the internet, so most of what you came by you still read in print or heard on the phone.

“They don’t really know how close we came,” he shuddered, his eyes showing the first signs of emotion – and fear – I had seen from him. That piqued my interest, and I engaged him, though without touching his precious hoard of scotch. I settled for a nice chardonnay. It turned out he was the second-ranking executive at one of the three largest banks in the country. He had been at the table in the NY Fed boardroom when 14 banks were forced to put in $3.625 billion to keep Long Term Capital from collapsing, with only Bear Stearns declining (one of the reasons they had no friends ten years later). The NY Fed president had essentially called all the heads of the banks, told them to be in the room, not to send proxies, and to bring their checkbooks. There was subsequently a lot of criticism of the Fed, but they did what a central bank is supposed to do in times like that: they made the children play nice in the sandbox. They were the only entity that could force the various monster-ego players to even sit in the same room with each other.

“No one will ever really know,” he said again. But of course, soon everyone did, as Roger Lowenstein wrote the must-read real-life thriller When Genius Failed.

“We walked to the edge of the abyss, and we looked over.” He proceeded to regale me with the stories of the negotiations, as the immensity of what would happen if they allowed the collapse dawned on the group one by one. They all had exposure to LTCM but did not realize the extent of it until it was too late. Looking back, it might have looked something like the credit crisis of 2008 if they had not acted, except it would have happened much faster.

I can tell you that no one in that room wanted to write a $300-million check. It was not good for their careers. Interestingly, after two years the fund was liquidated and the banks got back their capital plus a small profit.

Now, the bankers and leaders of Europe are getting ready to walk to the edge of the Abyss. It will be a long way down, and look like the 7^th level of Dante’s Inferno.

Their first real look will come in the next few weeks, as Greece is negotiating aggressively with its lenders as to how much of a haircut they will receive and what sort of guarantees Greece will provide on the remaining debt (they are balking at putting the new bonds in a legal jurisdiction that will have some real bite if they default again, which they will). They are also negotiating with Europe about how much additional real austerity they will have to endure in order to be allowed to take on more debt. If they walk away and there is an uncoordinated default, it will guarantee chaos. Bank collateral will collapse and credit default swaps will be triggered, including many sold by European banks that are already essentially insolvent.

The legal euphemism here is that if debtors “voluntarily” accept a 50% haircut, then no credit default swap protections will be triggered on those positions. But not all parties want to voluntarily take that loss (or an even greater one). If they are forced to do so, then the credit default swaps they bought come into effect. Greece can legislatively force them to take the haircut, but CDS contracts are written in such a way that that action would be seen as a loss, triggering the CDS insurance. The governments involved want everyone to accept, so there is no crisis. The funds simply want as much money as they can get back, and many are playing a very hard-nosed game.

Can the holdouts be enticed with sweeteners that not all may get? Maybe different collateral? Or shorter terms, or …?

The sad thing is that a 50% cut of the private lenders only gets Greece back to what will soon be 120% debt-to-GDP, from the current 170% and rising. 120% (which I consider optimistic) is just another, lesser form of insolvency, as Italy now understands. And if Italy is under pressure at 120%, then it is almost a given that the market would see Greece as still insolvent.

An Unintended (and Very Negative) Consequence

There is at least one unintended consequence arising from the Greek settlement negotiations. Private investors thought they were buying a bond that was “pari passu,” or equal with all other Greek sovereign debt. It now turns out they were buying junior, second-tier, subordinated debt. Something like a second mortgage on a home. You will take the first loss, so you then charge accordingly. But it now seems that the ECB, the IMF, and European public institutions are “more equal” than the private parties and will not have to share in the losses. The private lenders have found out they were taking subordinated risks while only getting senior-rate returns.

It the public lenders were involved in the haircuts, then maybe it would only have to be a 30% haircut, or if it was 50% it would be enough to maybe get Greece to the point where it might have a chance; and the remainder of the debt would be in better shape, rather than this just being the negotiations for the first haircut, with more to follow.

Every private lender in Europe now recognizes they are taking more risk when they invest in a sovereign debt instrument. This will have the effect of pushing rates up in the private market, like they have very recently climbed for Portugal (more on Portugal later).

Europe faces a set of choices. They can lend Greece more money on promises to turn things around, which can’t happen because of (1) the very austerity being imposed and (2) the 10% of GDP trade imbalance with the rest of Europe. But if they don’t lend the money and there is an uncontrolled default, they will get to inspect that Abyss more closely than they would like. It will mean hundreds of billions of euros in losses at their banks, which will have to be bailed out eventually by taxpayers.

Europe is worried about “contagion.” If Greece gets a 50% reduction on its debt, will not Portugal point out that they deserve it more? There have been deep fiscal cuts by the free-market government of Pedro Passos Coelho in an attempt to reduce the deficits, but estimates are that, even with those cuts, the deficit will still be 6%, falling only to 4% in 2013. And that is if things go well.

The market is not acting as if it expects things to go well. Yields on Portugal’s 10-year bonds climbed to 14.39% on Thursday. Credit default swaps measuring bond risk have reached 1270 points, pricing a two-thirds chance of default over the next five years.

While Portugal’s public debt of 113pc of GDP is lower than Greece’s, the private sector has much larger debts and the country’s total debt load is higher, at 360pc of GDP – much of it external debt. Jürgen Michels, Europe economist at Citigroup, says, “Without a sizeable haircut to its debt stock, Portugal will not be able to move into a viable fiscal path. We expect a haircut of 35pc at the end of 2012 or in 2013.”

Ambrose Evans-Pritchard, writing in the London Telegraph (I really like his work), notes:

Portugal is a troubling case for EU officials, who insist that Greece is a ‘one-off’ case rather than the first of a string of countries trapped in a deeper North-South structural rift. The official line is that Portugal will pull through because it has grasped the nettle of retrenchment and reform.

Europe’s leaders have vowed that there will be no forced ‘haircuts’ for holders of Portuguese bonds. If the country now spirals into a Grecian vortex as well they will have to repudiate that promise or accept that EU taxpayers will have to shoulder the burden of debt restructuring. While all eyes are on Greece, it is the slower drama in Portugal that will ultimately determine the fate of the eurozone.

A Preview of Coming Attractions

Let’s turn to some charts from a well-written report called “The European Crisis Deepens,” from the Petersen Institute, by Peter Boone and Simon Johnson. Both authors have a long list of credentials.

The first one is a chart of the cost of five-year credit default swaps. Notice they all are rising. (This is a log chart, so the scale rises by a factor of ten for each level.) Now, notice that Portugal is where Greece was last year. Then pay attention to the fact that Italy is likewise where Portugal was last year. Just thought I would give you a preview of coming attractions, horror-movie edition.

Then they offer us this chart, which compares the labor-unit costs of six countries in Europe. Only Ireland has seen their costs drop, as their labor has accepted pay cuts and productivity has increased. And pay attention to the ever-rising costs of France vs. Germany. This trend suggests France is on a path that Greece took. There are dragons down that path.

And it also illustrates the problem of why it will be so hard for Greece to turn around without being able to resort to a currency devaluation. They have to endure a 30% pay cut relative to core Europe if they want to compete. There will be no volunteers in Greece for such cuts. After two years of IMF and European institutional involvement (meddling?) in Greece, there has been hardly any movement in Greek labor costs.

Greece is not alone. Are you reading of any general pay cuts in the proposed solutions for Italy, where labor costs are now above those of Greece? Likewise, no move in Portugal (not shown in graph). The entire eurozone is out of balance, and no one is making any moves to deal with it or even acknowledge the basic problem.

Hallucinogenic Data and Other Fun Activities

Much of establishment Europe was predicting a positive GDP for the region only a month ago. The recent trend suggests the data they were smoking was hallucinogenic. And given the seriousness of the problem, it must have been primo stuff. Germany was in recession for the 4^th quarter of last year and is likely to be there this quarter, which is the technical definition of recession. Clearly, peripheral Europe is in recession, some countries in what looks like it could be called a depression. Below is the Purchasing Manager’s Index for six major countries in Europe. I have added a thick red line at the 50 mark, below which there is negative growth.

Gentlemen, Choose Your Disaster

With all of the above as a backdrop, let’s now see if I can outline the choices Europe faces. First, let’s take Greece, because it is instructive. Greece has two choices. They can choose Disaster A, which is to stay in the euro, cutting spending and raising taxes so they can qualify for yet another bailout; negotiating more defaults; getting further behind on their balance of payments; and suffering along with a lack of medicine, energy, and other goods they need. They will be mired in a depression for a generation. Demonstrations will get ever larger and uglier, as the government has to make even more cuts to deal with decreasing revenues, as 2.5% of their GDP in euros leaves the country each month. There is a run on their banks. Any Greek who can is getting his money out.

Greek voters will then blame whichever political group was responsible for choosing Disaster A and vote them out, as the opposition calls for Greece to exit the euro. Which is of course Disaster B.

Leaving the euro is a nightmare of biblical proportions, equivalent to about 7 of the 10 plagues that visited Egypt. First there is a banking holiday, then all accounts are converted to drachmas and all pensions and government pay is now in drachmas. What about private contracts made in euros with non-Greek businesses? And it is one thing to convert all the electronic money and cash in the banks; but how do you get Greeks to turn in their euros for drachmas, when they can cross the border and buy goods at lower prices, as inflation and/or outright devaluation will follow any change of currency. It has to. That is the whole point.

So how do you get Zorba and Deimos to willingly turn in their remaining cash euros? You can close the borders, but that creates a black market for euros – and the Greeks have been smuggling through their hills for centuries. And how do you close the fishing villages, where their cousin from Italy meets them in the Mediterranean for a little currency exchange? What about non-Greek businesses that built apartments or condos and sold them? They now get paid in depreciating drachmas, while having to cover their euro costs back home? Not to mention, how do you get “hard” currency to buy medicine, energy, food, military supplies, etc.? The list goes on and on. It is a lawyer’s dream.

There is a third choice, Disaster C, which is worse than both of the above. Greece can stay in the euro and default on all debt, which cuts them off completely from the bond market for some time to come. This forces them to make drastic cuts in all government services and payments (salaries, pensions etc.), and suffer a capital D Depression, as they must balance their trade payments overnight, or do without. Then they choose Disaster B anyway.

The only real options are Disaster A or Disaster B. Whether they opt to go straight to the drachma (Disaster B) is only a matter of timing. They will get there soon enough.

Why then do they wait? What’s the point of going through all these motions? Because Europe fears a disorderly Disaster B. For the rest of Europe, it is the Abyss. The Greek hope is that Europe (read Germany) keeps funding them in order to keep back from the edge of the Abyss.

As one European diplomat noted, “There is a growing sense that despite the valiant efforts of Papademos … the reluctant Greek establishment is biding its time to the next elections, banking on the assumption that the world will continue to bail them out, no matter what.”

Europe is getting closer to the point where it must make a decision about what to do with Greece. In theory, the deadline is March 29 for the next round of funding. It is a game with very high stakes and deadly serious players. Can Sarkozy be seen as weak and giving in to Greece, with elections coming up in April? Can Merkel appear to give in and keep her troops in line? There are elections not long after that in Greece. Can Papademos cave in to further cuts and promises on future debt that will be hard to keep and intensely unpopular?

The markets are getting exhausted. There will be no private market for Greek debt at any number close to what is sustainable. Greece will be on European life support for a very long time if they stay in and there is no disorderly default. It will mean hundreds of billions of euros over the decade, debt forgiveness, etc. There are no good choices.

And Europe will all too soon face what to do with Portugal, which will want to dispense some haircuts of its own. Don’t forget Ireland, which is very serious about not paying the debt the previous government took on for its banks in order to pay British, German, and French banks. That is a default that is in the cards. I think “polite” Ireland is just waiting until its $60-billion default is seen as small potatoes, which will not be too long, as Italy must raise almost €350 billion just to roll over current debt. Italy projects that its deficit will be down to 2%, but if Europe goes into recession that projection goes out the window.

The bottom line is that Italy (and most likely Spain at some point) cannot raise the debt it needs at rates it can afford without massive European Central Bank involvement. Rates are already approaching 7% again. That is unsustainable from an Italian point of view. Germany must be willing to allow the ECB to take on massive balance-sheet debt, or Italy will not make it without haircuts. And a mere 10% haircut for Italy dwarfs what is happening in Greece – and doesn’t do much for Italy. If they go for a haircut, it will be much larger. French banks holds 45% of Italian debt. Italy is too big for France to save. They cannot even backstop their banks if Italy becomes a solvency risk. They simply cannot get their hands on that much money without destroying their balance sheet. The most recent downgrade of their debt was just the first of many.

Speaking of downgrades, Egan Jones downgraded Germany from AA to AA- and put the country on negative watch. This is important, as this is what I believe to be the most credible rating agency; and over 95% of the time the other “Big 3″ agencies generally follow their lead, after a period of time. Part of the reason for the downgrade is all the debt that Germany is guaranteeing. Sean Egan was one of the first serious analysts to suggest that Greece would default. He was talking a 95% eventual default a long time ago. (Very nice gentleman, by the way. Or maybe he just left his Darth Vader mask at home when I met him.)

Europe will have to make its choice this year. Either a much tighter, more constrictive fiscal union with a central bank that can aggressively print euros in this crisis, or a break-up, either controlled or not. I don’t think they can kick the can until 2013, as the market will not allow it. Either the ECB takes off its gloves and gets down to real monetization when Italy and Spain need it, or the wheels come off.

The quote at the beginning returns to mind: “If we want everything to stay as it is, everything will have to change.”

Like any long trip, the drive (or flight) seems to take forever, particularly if you are very young or you are an investor. But then suddenly you are there. The LTCM crisis mentioned above took a long time to develop, but then it ended with a bang. One day Lehman or Bear is a big player and the next they are gone. I think this is the year the crisis moment for the euro arrives. Let’s hope they are ready.

What Europe Should Do

When Europe approaches the edge of the Abyss and looks over, the rest of the world gets to take a look, too. We can all be taken to the edge and over. I was reminded while in Singapore and Hong Kong how much we all need Europe to come through this.

Europe has problems that are structural and can’t be fixed with just another treaty or more ECB liquidity. With that in mind, here are my thoughts.

1. The European Union works, mostly much more than less. Keep the free trade zone. There are countries that work just fine that are not in the euro. We live in the world of computers. Currency exchange is a computer operation and relatively easy. And keep working on coordinating with the rest of the world. Take advantage of what you can do together. We are all better off with a united Europe. Until such time as there are stable labor and productivity markets across Europe, don’t press for a single currency. Single currencies don’t insure there will be no conflict. Really integrated free trade and open borders do.

2. Admit the euro just doesn’t work for some countries, and let them leave the eurozone (but stay in the free trade zone, like Denmark and Sweden are now). Establish as orderly as possible a path for a country to revert to its old currency. Yes, there are going to be some very large losses. If you control it, they will be far less than if you don’t. You can set up a two-tier system, just as you did when you created the euro. And pass some laws so everyone isn’t spending the next two decades suing everyone else. Deal with it like adults who want to be friends after the divorce rather than enemies for life. If you have to make up some rules, then make them up. But do it quick. The longer you take, the more it will cost you (and the world).

3. Greece has to be told no. No more loans. No more threats. If they want to stay, then let the market deal with them. I doubt it will be kind, but they have to take responsibility for themselves. Nobody forced them to borrow too much. Cut your losses now. Use the money to salvage your own banks. When (not if) Greece decides to go, help them with some humanitarian aid (medicines and emergency supplies) but stop piling on debt they can’t pay. Work out the terms so they can get on their feet and go on with their lives. Allow them to stay in the free trade zone. And learn your lessons. Be careful whom you lend money to!

4. Sadly, the same goes for Portugal, although with a reasonable and very healthy haircut they may be able to stay.

5. Ireland is not going to pay that bank debt. Get over it. Just let the ECB swallow it. Then Ireland will pay the rest of its government debt and can grow its way out of its problems. They have a positive trade balance. Besides, who doesn’t love the Irish?

6. Italy and Spain are problems. If they stay they are going to need some major ECB help on rates while they get their deficits under control. Either do it or don’t, but don’t keep the world in limbo. Germany needs to make a decision and make it very publicly.

7. I don’t know what to suggest to France. That is the toughest question. They are losing labor competitiveness with Germany and others, and already have taxes that cannot go much higher, large fiscal deficits, poor demographics, and huge future unfunded liabilities in the form of health-care and pension benefits. They have time to get things sorted out if they will use it (like the US). The world surely hopes they do. The concern about the problems of French banks was voiced everywhere in Hong Kong and Singapore. They are integral to world trade in ways that US banks (or others) can’t come close to. They just have the experience and infrastructure in making those trade loans. You can’t build that up in a short time. A problem with French banks would be a problem for world growth, which is already slowing down.

I know the markets are discounting a happy ending to the euro crisis. I just see the substantial “tail risk” and suggest you manage accordingly. Large pensions and foundations may be happy if they end the year where they started. Smaller investors should assess their risk tolerance from the perspective that Europe does not work through its problems.

Next week, we get to the US. If you think Europe has problems…

South Africa and Sweden

I came back to Dallas by way of Tokyo. As I walked to my gate, I noticed a crowd and then lots of cameras. Clearly a celebrity of some import was getting on the plane. I boarded and went to my seat in first class (you’ve got to love system-wide upgrades!). I asked the steward (who I knew from previous flights, which says I have been on too many) who was getting on. It turned out it was Yu Darvish, the best baseball pitcher in Japan, who Nolan Ryan had just signed to pitch for my Texas Rangers. He is young (25), good looking, and quite tall at 6’5″. And he seemed the perfect gentleman, smiling and quite willing to sign autographs. Yes, I got one, but it was for my kids. I’ll just save it for them for a while. The Texas fans are going to love him. He just has that charisma. Let’s hope he can keep his sub-2 ERA when he pitches in The Ballpark. Then they’ll go crazy.

The letter is already too long to write much this time about Hong Kong and Singapore, but I would be hard-pressed to say which city impressed me more. I was blown away. I thought I was prepared, but you really do have to see it for yourself. I am going to spend more time in Asia. And soon, thanks to the team at the Hong Kong Economic Journal. What an honor to work with such a venerable and prestigious paper. (They translate my letters into Chinese and give them a full page each Monday and Thursday, as well as post them online.)

Next week is busy with meetings, writing, and deadlines. Barry Habib comes to Dallas to help launch our new institutional research publication with Bloomberg. Then Wednesday a week I will be with Rich Yamarone (Bloomberg Chief Economist), Dr. Woody Brock, and Mark Yusko at the Annual Dallas CFA Forecast Dinner. We hope to be able to get together the previous night for some fun and maybe a little discussion of the markets (d’ya think?). The panel should be quite entertaining. Then I’m off to Cape Town, South Africa for two days to speak for Rand Merchant Bank at their fixed-income conference. (I will try and stay on Texas time if I can!)

It is time to hit the send button. It is the wee hours of Saturday morning and I am still on Asia time, it seems; but I need to get to bed and try to adjust. Have a great week!

Your hoping Europe works it out analyst,

John Mauldin

John@FrontlineThoughts.com

Although the book, which came out over two years ago, may have been regarded by some as too theoretical or impractical, so far the economy has essentially followed the slow-growth trajectory anticipated by the two economists. Since the economic trough in 2009, GDP has grown at an average annualized rate of only 2.5%, and at a rate of only 1.5% in the last four reported quarters.  Real personal income less transfer payments are still below the previous peak and industrial production has only come back to the level reached in 2005.  Employment is still at the same level as in early 2000, while real median income has declined in a recovery for the first time in the post-war period.

In our view, even the mild recovery seen to date is unsustainable.  When we look at the numbers, it is difficult to tell where additional growth will come from.  Although consumer spending, which accounts for 70% of GDP, picked up from June through November, this was accomplished largely by reducing the household savings rate from 5% to 3.5%, the lowest rate since the economy peaked in 2007.  Without even further reductions in this already low rate, there is little in the economic picture to drive spending. Household net worth is down.  Real wages and disposable income less transfer payments are not growing.  Employee hiring is still tepid.  Housing is still in the doldrums with additional home price decreases still likely as a result of the backlog of foreclosures.  Note, too, that December retail sales crept up by a paltry 0.1%, indicating that holiday sales were disappointing despite all the hoopla and exaggerated predictions following “black Friday”.

Government spending is another key area that is likely to be a drag on GDP.  The impartial Congressional Budget Office (CBO) is projecting a 1% decline in federal government spending in 2012 at the same time that states and local governments are also cutting back.

Exports, which have accounted for almost half of the GDP growth since the bottom, are another unpromising area.  Even if the European sovereign debt crisis doesn’t blow up, (not a sure thing), Europe is, at best, entering a recession and overall global growth is softening.  This week the IMF lowered its global growth forecast, saying that prospects have turned bleak as contagion from the European Union is spreading to the rest of the world—-and this was their base case.  Underlying their base case was a more ominous assessment of what could go wrong in Europe’s currently precarious position.  Anecdotal data indicates that China, too, is feeling the adverse effects of the global slowdown.  Although this is barely reflected in the official numbers, most of those who know China well regard their data as suspect.

U.S.  capital spending is also subject to strong headwinds in 2012.  Spending last year was boosted by the 100% accelerated depreciation allowance for items installed by year-end.  This probably shifted a significant amount of capital spending from 2012 to 2011.  Furthermore, in contrast to some economic theories, the empirical data clearly demonstrates that capital spending lags consumer spending by one or two quarters.  In other words, capital spending is a response to consumer demand, unless influenced by meaningful tax incentives.

Summing up, we see lower consumer spending growth, declining government spending at all levels, less exports and lower capital spending.  That pretty much accounts for the entire GDP.  The upshot will be heavy downward revisions in upcoming corporate earnings estimates and a negative shock for those looking at what they regard as an increasingly strong recovery.  Under this scenario the current market rally does not have far to go and the downside risks are high.

A big surge in civilian aircraft pushed durable goods orders up 3.8%. Ex-transportation, orders rose 0.3%. On a year-over-year basis, orders were up 12.1% overall, and 7.2% ex-transportation.

Both personal income and personal spending rose by 0.1% in November.

New home sales rose 1.6% in November to a 315,000 annual unit rate. Over the last few months, sales have picked up modestly, but from a very low levels, and house prices have continued to decline, down 3.8% last month to a median price of $214,100.

~

Originally posted at QandO.
Dale Franks
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The Commerce Department’s 3rd estimate of 3Q GDP was again revised downwards, to a 1.8% annualized rate.On a year over year basis, GDP was up 1.5% over 3Q 2010. The downward revision was led by a smaller decline in inventories and less growth in personal consumption.

Initial claims for unemployment fell for the 3rd consecutive week, down 4,000 to a much lower-than-expected level of 364,000. Continuing claims fell 79,000 to 3.546 million, the lowest level of the recovery.

The Chicago Fed National Activity Index fell to -0.37 in November from a revised -0.11 in October. Housing is still heavily negative in the report.

The Bloomberg Consumer Comfort Index climbed to -45 in the period ended December 18 from -49.9 the prior week.

Consumer sentiment continued to improve, to 69.9 in December from 64.1 in November.

The FHFA reported that house prices in October unexpectedly declined -0.2% after rising 0.4% in September. Analysts had expected a 0.3% rise in prices, not further downward price pressure.

The index of leading economic indicators rose 0.5% in November following October’s 0.9% increase. Positive elements include the treasury rate spread, building permits, consumer expectations, building permits, and falling unemployment claims.

~

Originally posted at QandO.
Dale Franks
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MBA Purchase Applications fell -2.6% overall last week, with purchases dropping -4.9% and re-fis falling -1.6%. So the positive housing numbers we’ve seen so far this month haven’t affected actual sales. Interest rates are attractively low, but that is balanced by poor employment conditions, tight credit, and a lack of equity.

A sweeping revision to the data method has sharply lowered the last 5 years of existing home sales reports. But last month, sales rose 4%, anyway, well above expectations, and the rest of the report is pretty positive, too, with housing prices firming up, and supply falling. Also, the gains are concentrated in single-family dwellings, and well-distributed geographically.

~

Originally posted at QandO.
Dale Franks
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Housing starts jumped 9.3% to an annual rate of 685,000. But that jump is led by a 25.3% jump in multi-family dwellings, so don’t assume that individuals are getting ready to buy single-family homes again. Also, the surge is led by a 53.8% increase in the Northeast, balancing off an  18.2% decline in the Midwest.

ICSC-Goldman reports a big bump in retail sales, up 3.4% for the week, and 4.6% over last year. Redbook, however, shows a far more modest increase, with same store sales only up 0.5% from last week, at 3.4%, while the month-to-month number is actually down -2.7%. That doesn’t bode well for the government’s retail sales report for December.

~

Originally posted at QandO.
Dale Franks
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